A well known leading indicator of the direction of the market is Copper (/HG). Copper prices tend to track positively with global equities, which in turn react far ahead of overall global expectations. This is interesting because Copper is at multiyear lows.

Today, Pete Mulmat of the CME Group joins Tom Sosnoff and Tony Battista as they discuss this relationship. The guys talk about how you would be able to get long Copper and short the S&P 500 in a classic pairs trade. This trade would take advantage of both price extremes and is a looking for a reversion to the mean!

Tom: No. She was fine. It was you.
Tony: We're live. We're back. Closing the Gap, Futures Edition.
Tom: Don't worry, Pete. This happens every day. All day long.
Tony: You missed me yesterday. That's what it was.
Tom: I did not miss you.
Tony: You're just annoyed I didn't … Hello, Pete. Welcome. Welcome back to tastylive.
Pete: Hey. Good to see you, Tony.
Tony: You're just annoyed I didn't call you for New Year's. I know what it's like.
Tom: I'm not annoyed.
Tony: You're not my top dog. All right? You're a sure thing, but you're not my top dog. You're like my go-to, when I don't want to work.
Tom: When nobody else will pick up the phone, I'm you're go to? Yeah.
Tony: Evidently somebody picked up the phone.
Tom: How are you?
Pete: I'm good. How are you, Tom? How's ..
Tom: How was your holiday?
Pete: Mine was great. Yours?
Tom: It was good.
Pete: Good.
Tom: Yeah, looking forward, you and I will both be … Linda, do you want to fire it up real fast, because a lot of people don't know that Pete will also be out in Scottsdale, or Phoenix.
Pete: In Phoenix.
Tony: One of those places.
Pete: Right.
Tom: Somewhere close to us. It's somewhere in Arizona.
Tony: I gotta deal with this everyday, Pete. Everyday.
Tom: Linda, please put it up there, just to … So next Saturday, a week from tomorrow, we will both be at the JW Marriot in Scottsdale. What time are you going to be speaking?
Pete: I think about 12:45.
Tom: 12:45. And I'll be speaking about 2, and so if you want to come out there, and you want to meet, and you're out there all day?
Pete: All day.
Tom: So you can ask questions. You can bother the hell out of Pete. He lives for it. Feed him.
Pete: Yes. [crosstalk 01:43]
Tom: No, but seriously, its very rare to have an opportunity to meet somebody that's clear of the concept with respect to all the products and stuff. We get tons of crazy questions. They're not crazy, I mean they're reasonable questions about futures, and futures are harder for us because there are so many different products and multipliers and times. There were a couple questions last weekend, I had to … I'm Googling. I'm Googling everything because you can Google a lot of the stuff, but sometimes it's just easier. Especially if you have questions about different pairs and the relationship between them and things like that. You can help with those tremendously.
Pete: Right, and you know what? It's a great way to do that. People have come out. It's been a such a great response, and its really fun because we get a minute to break down ideas, talk through stuff. A lot of stuff we've done on the show, so it's been very exciting.
Tom: Again, there's not a lot of free resources out there and especially free resources where a person knows what the hell they're talking about.
Tony: That are good. Right.
Tom: Because there are a lot of free resources. It's just not that good.
Tony: When it's free, you can afford it, but when you come to Pete, you certainly should do it.
Tom: There are a lot of pay-for resources too. So this is just a nice, very nice opportunity. Hey, let's … Give me a little break down. How are we starting off 2015? What are we doing?
Pete: What are we doing in terms of overall market or this particular segment?
Tom: No. About what we're talking about today.
Pete: Oh, this segment.
Tom: If you know what's going to happen in the overall market, that makes you far more valuable.
Tony: Your market opinion. His market opinion. I could care less about.
Pete: Okay. Today we're working on …
Tom: Please tell everybody you don't know what the market is going to do in 2015.
Pete: I have no idea what the market is going to do.
Tom: Thank you.
Pete: That's what kind of caught me off guard.
Tom: You've only been doing this for, what, 25 years?
Pete: Today we're focusing on copper. Copper and the relationship to the S&P, and really interesting trade. We've looked at gold and silver as a pair. We've looked at a lot of different pairs trades and, what you said, the idea of how do you start to construct these pairs trades? How do we look at the notionals? And we're going to keep this, hopefully this year, we're really going to start going into the mechanics of how we structure these trades. How we build an idea of …
Tom: So how do you come up with something like … Just, I'm going back in your mind. You're preparing for today's show, and we give Pete a lot of room, because we're introducing professional strategies for retail investors,a nd we found this to be one of the most valuable segments we've done because we're introducing people to lots of new products, myself included. I traded copper maybe 4 times last year. There was one little swoosh that we traded copper. We did okay, but we did okay because we traded really small and we bought it into some severe sell-offs, so it worked out okay.
Pete: Right.
Tom: But I don't generally trade copper. Why copper and S&Ps? Like, that's what people want to know.
Pete: Right, and you know what? Here's the thing. Copper is a true, if we go back and look over the last 20 or 30 years, there is a … I actually didn't run the correlation but there is a very high correlation between the movement of copper and the overlying economy. If you think about it, copper, unlike silver, unlike gold, it is a base metal. Every house that's built on average about 450 pounds of copper. Every car that's put on the road has between …
Tom: 450 pounds of copper?
Pete: 450 pounds of copper. Every car has between 40 and 60 pounds of copper.
Tom: Really?
Pete: Yeah. If you think about all the …
Tom: Where's copper in the car?
Pete: All the wiring.
Tony: Same place it is in your house.
Tom: Oh God. Help me, Lord. Help me. It's going to be a long one. If this is how 2015 is going to … I'm not a religious person.
Tony: I knew I should have gotten you like a tool set for Christmas, because I'm sure you don't have one.
Tom: While our research team is listening, and we have those guys on video, will you guys pull up the correlation going back 3 months, 6 months, a year and as far back as you can go between copper and the S&Ps? I'm just curious myself.
Pete: Right.
Tom: We have a correlation study built into our database.
Pete: Yeah, and the guys are fantastic, and honestly I was working on this, just trying … Copper is sitting right near its lowest. Now we're at a unique time, trading. We're end of the year, so the strategy, and, this is one of the great things you're doing on the show, is you can look and go back kind of in my Rolodex of ideas and find things that are working, and this has really been a tremendous opportunity, really, a lot of fun being able to do this.
Tom: Go ahead.
Pete: Copper futures are one of the most actively traded industrial commodity markets. For many, it is also seen as a leading economic indicator.
Tom: So what would be some other industrial commodity markets? I'm just curious, just to compare copper to, what?
Pete: You know, that's a great question, and it's something we're going to talk about today. Crude is really an industrial commodity market. Iron ore is an industrial commodity market.
Tom: Got it. Got it. Okay.
Pete: Now copper, is off 17 percent from the beginning of last year to the close, which seems substantial. That's a pretty big sell-off, but when we look at iron ore off 52 percent, crude off 50 percent, you know, we can make an argument, yes, copper is soft considering how strong the equities markets are right now. We've seen copper off 17 percent, while the equities, we ended up the year, 14 and a half, 15 percent in the S&Ps, I think? Not quite that much.
Tom: A little less, 13 something. Whatever. Close enough. Close enough.
Pete: Truly a divergence. Oft times we see copper lead the turn in both directions. So we've had some unique things, though. Again, just jump back to slides. Speculative activity influences copper prices on a short-term basis, but over the years, as the correlation, as we'll see, price trends generally remain true to the direction of the global economy. Copper prices tend to track positively with global equities, which in turn react far ahead of overall global economic expectations.
So oft times, copper, we like to look at it as a leading indicator, so if copper is incredibly soft, are we seeing demand? Are we seeing, again, those cars, those houses all that are used. Copper is such a critical component of it. If we're seeing a softening in those, in the price of this metal, are we seeing a softening of the economy, and oft times, that correlation holds pretty well. So major turns in copper prices have often coincided with turns in equities in the past. With a copper price recovery predating the sub-prime bottom in stocks by as many as two months.
Tom: That's interesting. I didn't know that.
Pete: Yeah.
Tom: I actually didn't know that. That must be pretty much in line with … That's pretty much in line with volatility and lots of other things. I didn't realize that copper, like, I guess we just don't look at copper as one of the …
Pete: You know? And again, yeah. It's funny because usually people will have gold, possibly, gold and silver up on their screen.
Tom: Yeah, I'll look at … exactly.
Pete: Copper fits up there as a group, but you're using copper in a different way to determine opportunity. Therefore, with US global equities carving out a large number of new daily highs, as we've seen, one might suggest that copper prices are poised to react to the anticipated improvement in global economic, excuse me, in the global economy being exhibited by equities.
So base is a long-term correlations, with equities broaching all-time highs, copper incredibly soft, closing on its lows. Now there's a lot of effects in terms of some concerns about Chinese demand and Chinese financing, the Chinese had financed copper, incentivized buying copper for many years as a way to basically have an inflation hedge. Now they have stopped doing that. That's brought a little bit of supply on. So here is a chart which gives us a representation, and this is going back, 1994, I think, which again shows you, in green is copper, in red is the S&P 500. So for the most part, we can see that the two do, to a great extent, track one another in movement.
Tony: Now what's the relationship with … Sorry for jumping in, but I'm just curious.
Pete: No. I would …
Tom: So what's the relationship, notionally, between, one contract of S&Ps is a 100,000 dollars, notionally. What's on contract of copper?
Pete: One contract of copper is 25,000 pounds of copper, so and we always know again, notional is so important.
Tony: Well, that's about 3 dollars? I don't know what that is.
Tom: 282? Okay.
Pete: So it's roughly about 71,000 dollars in notional, so …
Tom: Okay, and the implied volatilities are somewhat similar, right?
Pete: Actually, the implied volatility right now in copper is higher. It's closer to 28 percent.
Tom: Wow. 28?
Pete: Yeah.
Tom: So that means the relationship from a pair standpoint is pretty much one-to-one?
Pete: Well that's … yes.
Tom: Is that how you would trade it?
Pete: That's the way I would trade it, yes.
Tom: Okay, fine. Okay.
Tony: A point meaning, like, from 281 to 280 is 250 bucks?
Pete: Right.
Tony: Half ticks are 12 dollars?
Pete: It's traded in tenths of a set.
Tony: Tenths of a set.
Pete: So yeah.
Tony: Half ticks would be 12.50?
Pete: I'm sorry. It's traded in one half of one cent.
Tony: One half of one cent. Got it.
Pete: So .005, and that's 12 and a half dollars, so right now I think our price is 281 …
Tony: 282. Yeah, 281, 282, so if it goes to 283 on a warm up …
Tom: 250 bucks.
Pete: Then it's 250 bucks, right.
Tony: This is a big guy. It's a big guy. It's a big guy.
Correlation, just since we took a little break here for a moment, 1-year correlation team saying it's about .55 percent. One month is basically nonexistent. Three months is about .14.
Tom: And one year is what?
Tony: 0.55
Tom: .55, so …
Tony: That's the correlation between copper and the S&P 500.
Tom: That's interesting because …
Tony: That's a fairly strong correlation for one year, and then it breaks down over the last year.
Tom: Yeah. Yeah. So there's a long short basis there, and I guess what you're saying here is we'd be selling S&Ps and buying copper, because copper's on it's low. Obviously S&Ps, on, well …
Tony: If you're a contrarian, and you think that that's going to …
Tom: Well, of course.
Tony: Well, I mean …
Tom: But that's the trade, and then there's also they're notionally close to each other, and just to give you an example, S&Ps are up 11 today, which would be on 1 S&P, which would be, let's say, 550 dollars, and copper is …
Tony: It's had a big move already this morning of 28.
Tom: It's had a 4 cents high-to-low move, which would be 1000 dollars, but right now it's only down 125 dollars. So it's very interesting.
Tony: It's widened even more from the way that would look.
Pete: Yes it has, and again, this is, you know, we're in this interesting time. We're into the new year. We say that last push down through all of December, and again, hitting it really hard at the end of the year. So I like the idea that this relationship does track well over time. Again, we have to take into account that it's still sitting awfully close to the lows, so when we look at this idea of a reversion, especially not everybody's back in right now. I think this is a really interesting way to express an opinion on this, with a little protection from the S&P side, but again, we're …
Tom: So, so far, this conversation has centered around a pairs trade, which is S&Ps versus copper, but you can do the same thing if you're doing S&Ps. Like, I have an S&P position versus bonds right now, which is one-to-one. I mean, the beautiful thing about trading different futures pairs like this is you can pick your underlying, and as long as you understand kind of roughly what the implied volatility is on the notional equivalent, it doesn't matter. Like, let's just say your neutral S&Ps, here. You don't want to get short S&Ps, but you want to be short bonds. You could theoretically do the same spread, which is short bonds, long copper.
Pete: Right.
Tom: Now there's no strategic edge in this. This is a pricing decision, but you're basically saying is, "Hey. One of these spreads is going to revert to the mean. At some point they're going to cross back over the other way, at some point in 2014." Like, right now, while Pete's talking, I'm trading a pairs trade where we're selling …
Tony: E-mini S&Ps.
Tom: We're selling E-mini S&Ps, and we're selling bonds, because bonds just rallied 14 ticks from their lows, and S&Ps are on their highs. Now, I'm going to do that copper trade in one second, but I'm still learning about it.
Pete: Okay.
Tom: Okay? Because I'm going to do that copper trade … Here, let's do it, because I actually want to have this on while we're talking.
Tony: So you'll be selling E-mini S&Ps and buying copper.
Tom: Buying copper, because it's been a long time since we've traded copper. Hang on, Pete. I just want to do this because, again, it's important …
Tony: So if the correlation over the last months or so were to revert, the position that Tom's putting on now would be profitable.
Pete: Right.
Tony: If it stays the same, then the position he's putting on, or gets worse, would be worse.
Tom: So a tick is a half … There's no in between, right?
Pete: It's .005, so it's half a cent.
Tony: Yeah, there are half ticks, also.
Pete: Yeah.
Tom: Yeah, but it's … okay. Anyway, I did it, so there.
Pete: All right.
Tony: So there!
Tom: So there.
Tony: So, spite you.
Tom: So I sold S&Ps and bought copper, and we'll take a look at it later. I just wanted to have the position on, so I have something to do, so [crosstalk 15:01] …
Pete: Right.
Tony: Plus it's a hedge against the copper in your house and your car.
Tom: Yeah. It's a hedge. Exactly, so …
Pete: Yes.
Tony: You're going long, long, in case you want to buy a new car.
Tom: Exactly. In case it … You can put through both of those. They're separate pairs trades.
Tony: Oh, I can do my job?
Tom: Sorry. Sorry about that.
Tony: Sorry, Pete.
Pete: No, this is …
Tony: Mommy and daddy are not fighting. They're just having a discussion.
Tom: So, I don't care what the reason is that copper's lower. People can say that the Chinese market is soft. Whatever it is, but in reality, maybe, but last week was one of the best weeks ever for FXI, so you don't know which is their ETF. You don't even actually know how that translates.
Pete: Right.
Tom: I like the idea that there's this pairs dynamic out there, and that hopefully there's some reversion to the mean inside that dynamic.
Pete: Right, and that's really what we're looking at, and one of the things we haven't talked a lot about is the idea of open interest, and how open interest works in the futures market, which is a little different …
Tom: How does it work? Because I really know.
Pete: Oh, okay. Well, open interest is basically the open or outstanding overnight commitment of open positions in the market. So if you and I, if you buy a contract and hold that overnight, that counts. That buy, and that corresponding, whoever sold it to you, counts as one contract of open interest. So everything done intra-day and closed out, if everybody did everything flattened up at the end of the day, there'd be no open interest in the contract.
Tom: But how's that different from, like, listed options? Is there a difference from?
Pete: Oh, from listed options? No. I'm just … I'm …
Tom: Okay.
Pete: There's not from listed option, no. From cash equities, this idea of open interest doesn't exist.
Tom: Okay, got it.
Pete: So this open interest is … Actually, there is a report that's put out by the government that's called the Commitment of Traders Report, and it breaks traders down into three groups, basically: hedgers, and large speculators, CTAs, hedge funds, and then small speculators. This, again is another tool you can do. It's a backward looking tool, so it comes out every Friday, but it's from 9 days ago. So remember, its usefulness is a snapshot into what some longer term people are thinking. Again, the market of individuals and large speculators heavily short the market right now, so we're seeing a lot of short interests in the market. This is just again a quick snapshot into, in terms of supply, supply around the world is 70 percent below the peak in 2013, so it, you know, when we're looking for opportunities, we want to start to find some legs to put under the idea of reversion. At least I do.
Tom: Sounds like we should be buying copper instead of hamburgers, right, Tony?
Tony: Sounds good.
Tom: We should definitely be buying copper. You, I wonder, in the futures world, do they have … One of the cool … One of the things I've always liked about … I don't know what it even means, but I've always liked kind of that "days to cover" you know? Like, how many days it takes to cover? Do they have anything like that in the futures world?
Pete: No.
Tom: No, they don't. Okay.
Pete: No.
Tom: Yeah. They had that in that crazy stock … I don't even know if it's real, but it always sounded good on paper. So if we want to trade the relationship between copper and US equities, how would we create a trade that gives us exposure in both markets? So what I did here is actually just this trade. I just bought copper at just a little under …
Tony: 2.818.
Tom: Oh, 2.818, and 2.818, whatever. Just a little under …
Pete: So that's 2 dollars and 81.8 cents a pound.
Tom: Right, and I just sold S&Ps at 64 instead of 54, so I bought copper a little bit cheaper than you have up here, and I sold S&Ps a little bit higher.
Tony: 10 dollars higher.
Tom: 10 dollars higher, so I'm just taking advantage of today's … We just got lucky. I don't even know if we got lucky. Maybe we didn't get lucky. We'll find out if we got lucky later on. Yeah, but …
Pete: Right.
Tony: It's at a better price than it was on the slides the way you did it, because you bought copper, which is lower, and sold E-mini S&Ps, which is higher.
Tom: This is correct. I'm actually surprised that copper implied volatility is that high. It seems, as a commodity, it just seems high, because it doesn't seem like there's a lot of commodities with a 30 percent implied volatility.
Pete: Right.
Tom: But maybe it's not for copper, I just don't … I haven't followed it long enough in my career.
After the steep fall in copper, as we've seen we may want to look for a bounce between HG relative to ES. That's kind of what we're doing, and in that case, this is a little bit of a delta long position.
Pete: Right. In this one here? Right. We strictly hedge basis, I mean, we strictly created the pairs trade basis to notionals, So when we go back and look at those notionals …
Tom: And based on margin, too?
Pete: Yeah, so this is … though, doing it with strictly futures based on notional, we're buying three copper. We're selling 2 S&Ps, which gives us about 210,000 dollars of exposure in each, but it's an expensive trade, at almost 19,000 dollars in margin.
Tom: There's lots of different ways you can look at pairs trades, and there's lots of different ways you can tweak pairs trades, which is, again, this is the non-strategic piece to what we do. The strategic piece means that there's premium decay. That's all that means, and it's more related to where … Can you ask the research guys, too, where is copper, IVR-wise?
Tony: Okay.
Tom: I'm just curious. So that would be more strategic for us, relative to implied volatility rank, but what this is is directional bet, and you can tweak any pairs trade, no matter what it is, bonds, stocks, NASDAQ, Russell, I mean, whatever you want to trade, or not Russell, but copper. It doesn't make any difference to us. You can tweak it to make the margins line up, which usually gives you some idea of how regulatory risk is perceived, or you can do it like in this case, because this is not adjusted for implied volatility.
Pete: This is not.
Tom: So this would be considered, in my mind, a little bit low on copper, which may be the right play.
Pete: Right.
Tom: You may be more bullish on copper than you're bearish in S&Ps.
Pete: Right.
Tom: You make this kind of adjustment.
Pete: Right. Absolutely. If you want, again, if you want that greater exposure in copper, and you just want a little bit something in case you're wrong, that setup is a very classic, traditional way to do it. Now this one's looking at it in a little bit different way. We actually …
Tom: There's a theta component.
Pete: We bring in a theta component. We bring down the cost of the trade a little bit.
Tom: Yeah, I like it a lot.
Pete: And what's nice about this is, you know, copper options trade, but the bulk of them still trade on the floor. We're working on building that liquidity.
Tom: Yeah. So you're buying copper underlying, and selling S&P options.
Pete: Yes.
Tom: You always do the hardest … You always to the most liquid … When you're doing this type of trade, it's always the option of the most liquid underlying, which is S&Ps.
Pete: Right. Right.
Tom: So, this is a no-brainer.
Pete: Yeah.
Tom: I mean, no-brainer which one to choose.
Pete: Right, and this one is nice because it actually gives you a little bit of, again, and we weighted it [basised 21:47] looking just at the deltas, and coming up with the weight of it that way, and we came up with this buying 1 contract and selling 2 out-of-the-money calls. And it is a more capital-efficient way, again, a kind of a different slice, a more strategic slice, of getting exposure to this relationship.
Tom: Yeah, this would be, theoretically, also a little bit low on copper, because what you're doing here is 2 out-of-the-money calls. You're probably at a delta of about .7 versus 1, and so you're a little bit low on copper in this case, but you're collecting a premium decay, and what's nice about this trade is that it's potentially taking advantage of the high implied volatility that we finished the year on in ES.
Pete: Right, and that's what I kind of liked about that. I felt comfortable, at this point, taking a look at that opportunity to bring the cost of it down a little bit and find a little of a way for it to pay me while it sets up.
Tom: Let's just see. If we did this, we'd be trading February ES. No, let's see. We'd probably have to do GN, just because you can't do it yet.
Tony: So, while you're looking at that, Tom, if you'll look at JJC, that's an ETF on copper that looks like it's an unleveraged investment in the futures. It looks around 74 percent IVR rank. Can't get an IVR rank on forward slash HG, which is the future.
Tom: That's good. All that's doing is supporting the argument for it's probably at an extreme, implied volatility-wise.
Pete: Right.
Tom: We just want to see. We weren't advocating trade in the ETF, because it doesn't trade. We just wanted to see where it is, pricing-wise, so that we know where copper is. We need to put context on the 29 percent.
Pete: Oh, 29 percent. Sure.
Tom: So the 29 percent's in the 75th percentile.
Tony: We don't know … right. For the last 52 weeks is basically what we're looking at, so is it relatively high for that price, which we haven't traded for a long time, or is it low? It's actually very high. We should be good.
Tom: Yes. So if we go up to 20.85, just so you know, 20.85. Yeah, these markets are a little wide right now. They're about 50 cents to 75 cents wide in the ES options. I'm going to wait until the market opens in a couple minutes.
Pete: I was just going to say …
Tom: And then they'll be a quarter wide.
Pete: Right.
Tom: And then we can do this trade, 2 to 1.
Pete: Great. Good.
Tom: Thanks so much, Pete, that was great.
Pete: Tom, Tony, thank you so much for having me.
Tony: Be back in 90 seconds, because we have the opening bell next.
Tom: Oh, we have delta 80 on there. Perfect. Okay. I didn't see the delta