Arbitrage

Given the recent swings on both LME and CME copper, it is worth understanding what arbitrage is, and how it can impact your trading decisions.

Arbitrage itself is a relatively simple subject - arbitrage, or 'arb', is the simultaneous buying and selling of a commodity to exploit price differences in two different markets/exchanges for that same commodity. There are many different markets and commodities this occurs on between the LME, CME, SHFE, MCX, etc. where the same metal is traded on each exchange, but an there is an inevitable price difference between the exchanges for the same metal. We will focus here on one of the most traded arbitrages - LME and CME copper.

An arbitrage trade is necessary to hedge physical trades if you are pricing a purchase and a sale on two different exchanges. When you hedge your purchase you will enter into a short futures position. However when you hedge your sale, your futures long positions will be executed on a different exchange, hence it will not square your original short position. You will be left with open short and long futures positions on each exchange, and the value of those trades will continue to fluctuate. To square those positions and prevent those fluctuations in value, you will enter into an arbitrage futures trade whereby you buy futures on the same exchange you bought your physical parcel on, and sell futures on the same exchange you sold your physical on. In the case of exporting 1000MT of CME-priced metal to sell against an LME-priced sale, your trades would look as below. Remember, CME copper trades in lot sizes of 25,000 lbs (equivalent to 11.34 mt), so there will still be a very small mismatch between the two exchanges, but this is to some extent unavoidable.

Arbitrage trade to square an LME long and CME short futures position

Historically, the LME/CME copper arbitrage floats between $0-100/mt either LME in a premium over CME or vice versa, CME in a premium over LME. Spikes outside of this range are often short-lived and are mainly linked to short-term supply disruptions in either market, physical deliveries into exchanges, or sometimes speculative plays by traders in these markets.

Let's say that the LME/CME copper arb moves to CME $150/mt over LME. Speculators might sell CME copper and buy LME copper in the hope that the arb moves back to CME in a $50/mt premium over LME. At which point they would look to take profit and buy CME copper/Sell LME copper and profit $100/mt from that trade. Based on trading patterns over the last 40 years, this has been a fairly reliable trading strategy, but as you can also see from the below chart, history is no guarantee of future patterns.

Comex copper squeeze May 2024

Sometimes market conditions can change rapidly and cause major disruptions to expected patterns. This is what happened this month on the LME/CME copper arbitrage. Traders began placing bets (selling CME/buying LME) when the CME premium reached levels of $150, $175, and $200/mt over the LME. However, these trades coincided with a large number of bullish outright bets on the CME front-month copper contract (in this case July), which pushed the CME premium over LME above $300/mt, then $400/mt in short fashion. The traders who had sold CME/bought LME started to face large mark-to-market losses on those speculative positions. Some of them had stops in place that started to get triggered and led to more buying of CME copper/selling of LME copper, further driving the CME premium higher. Those that didn't have stops in place, but were facing even larger losses started to scramble and try to close their losing positions. But by that point liquidity had started to come out of the market as participants were aware of the situation, causing the CME premium over LME to start gapping higher - this is what is known as a short squeeze. Those with losing (out of the money) short positions need to pay higher and higher amounts in order to close them, adding fuel to the fire. This resulted in the CME front-month contract trading in a nearly $1300/mt premium over the LME by the time the short CME positions had been closed out.

You might be thinking, well it doesn't impact me, that's just speculators. However, if you were a physical trader that was exporting CME-based copper from the US or South America against a physical sale in Asia, your arb trade required to mitigate your cross-exchange price exposure would be to buy CME copper and sell LME copper. Had you not been managing your positions carefully and been forced to execute your hedges at market, you may have been facing a +$1000/mt loss on your physical trades due to the CME/LME arbitrage at the time of execution. At the same time, if you were following and understanding these markets, you would have been able to capitalize on them by importing metal into the US that was originally priced on the LME, and executing an arb trade of buying LME and selling CME in order to capture those gains.