Copper is a commodity that is used across many industries including consumer products, construction, and power/electric.
Copper futures are one of the most popular traded product in the industrial commodities markets and are generally seen by traders as a leading economic indicator. Speculative traders can influence copper prices in the short term, but over the years, coppers tends to trend in the direction of the global economy. Because the price of copper tracks so closely to global equities, copper prices tend to react far ahead of global economic expectations.
Over the last year, copper has been seeing a decline in price because of the decreasing copper demand coming from a Chinese economy that is showing signs of slowing down. Because China is the world’s largest consumer of copper (40% of demand), changes in the state of the Chinese economy can dramatically swing the price of the copper futures.
Another interesting aspect of the copper economy in China is the fact that copper is used as collateral for financing deals. This means that Chinese companies can borrow money from other countries at a low rate of interest and invest that money into higher yielding Chinese assets while using copper to finance the loan. The loan can then be paid back utilizing the return from the investment.
There is a strong relationship between the Australian Dollar (AUD) and the Chinese economy due to the fact that Australia is a large exporter of commodities and China is a large importer of commodities. Therefore, when the Chinese economy is doing well, the Australian dollar reflects that because China is generally importing a lot of commodities from Australia. This is why the Aussie is commonly referred to as a ‘commodity currency’.
Because the AUD is so strongly correlated to the Chinese economy, then that also means it has a strong positive correlation with the price of copper as well (not to mention the fact that Australia is a large exporter of copper).
Copper Future Specs (/HG):
Contract Size (leverage) - 25,000lbs
Current Price - $2.2705 *
Notional Value -$56,762 * = ($2.2705 x 25,000)
Tick - 0.0005 ($12.50 /tick)
Australian Dollar Specs (/6A):
Contract Size (leverage) - 100,000 AUD
Current Price - $.7317 *
Notional Value -$73,170 * = ($.7317 x 100,000)
Tick - 0.0001 ($10.00 /tick)
Micro Australian Dollar Specs (/M6A):
Contract Size (leverage) - 10,000 AUD
Current Price - $.7317 *
Notional Value -$7,317 * = ($.7317 x 10,000 AUD)
Tick - 0.0001 ($1.00 /tick)
As mentioned, the AUD and copper are correlated. You can see below that there is a fairly strong correlation between the 2 products in the near term, that decreases as we looking farther back.
AUD (/6A) To Copper (/HG) Correlations
1 Month: +0.52
3 Month: +0.46
6 Month: -(0.31)
If we feel like copper is undervalued (because it has been on the decline for some time) and we want to take a position to get long copper, but also take advantage of the increase in short term correlation between copper and the AUD, then we buy a copper future and sell the AUD future (/6A).
This gives us long exposure to the copper market while hedging the position by going short the AUD and allows us to make a play at the possible divergence of the two products in the short term (since the short-term correlation is so much higher than the 6 month correlation).
In a 1 to 1 pairs trade like this, the notional value of the AUD is higher than copper, but to help keep the position smaller, we look buy and sell only 1 contract for each product.
If we want to take the opposite side of the trade (bearish copper) and make the position even smaller, we can sell the copper contract and buy micro AUD contracts to hedge the position. Because the micro AUD contract is 1/10 the size of the regular contract, then we have to sell a few extra contracts to get the notional weighting a little bit closer.
Strategies: Pairs Trade
Products Discussed In This Episode: /HG, /6A, /M6A
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