Just Borrow The Spread

When it comes to mitigating spread risk, companies take different approaches. Risk-averse firms borrow further out, locking in spreads and reducing uncertainty. Others take on more risk, hoping for additional profits.

But let’s look at this logically: for physical traders, being 𝘭𝘰𝘯𝘨 𝘴𝘱𝘳𝘦𝘢𝘥𝘴 has much greater upside and lower downside than being 𝘴𝘩𝘰𝘳𝘵 𝘴𝘱𝘳𝘦𝘢𝘥𝘴.

Here’s why:

🔹 Physical traders typically own metal before they sell it. That means they’re naturally short futures—creating a borrowing requirement.

🔹 Borrowing involves buying a nearby futures contract and selling a later-dated one. The value of this carry trade depends on the forward curve:

✅ 𝗖𝗼𝗻𝘁𝗮𝗻𝗴𝗼 → Prices rise over time.
❌ 𝗕𝗮𝗰𝗸𝘄𝗮𝗿𝗱𝗮𝘁𝗶𝗼𝗻 → Prices fall over time.

𝗧𝗵𝗲 𝗚𝗼𝗹𝗱𝗲𝗻 𝗥𝘂𝗹𝗲: 𝗕𝗼𝗿𝗿𝗼𝘄𝗶𝗻𝗴 𝗶𝗻 𝗮 𝗕𝗮𝗰𝗸 𝗶𝘀 𝗕𝗮𝗱

If you borrow in a backwardation (buy high, sell low), you’re locking in losses. But borrowing in a contango can be a profitable trade.

📌 𝗞𝗲𝘆 𝗶𝗻𝘀𝗶𝗴𝗵𝘁: Contangos are 𝘤𝘢𝘱𝘱𝘦𝘥 at full finance costs (interest + exchange rent). If a contango were to exceed this, traders could execute borrows, hold warrants, then deliver them against the short position from the carry - a risk-free profit. When contangos approach full finance, demand for the trade increases, capping the spread.

Backwardations, however, have 𝘯𝘰 𝘶𝘱𝘱𝘦𝘳 𝘭𝘪𝘮𝘪𝘵. If you need to borrow in a backwardation, you’re at the mercy of whoever will lend—often at painful rates. Extreme backwardations can be triggered by:
✔ Supply shocks 🚢
✔ Large speculative positions 📊

This is why it’s better to be 𝗼𝘃𝗲𝗿-𝗯𝗼𝗿𝗿𝗼𝘄𝗲𝗱 𝘁𝗵𝗮𝗻 𝘂𝗻𝗱𝗲𝗿-𝗯𝗼𝗿𝗿𝗼𝘄𝗲𝗱. The downside of lending a spread? A slightly bigger contango. The downside of 𝘯𝘦𝘦𝘥𝘪𝘯𝘨 to borrow? A potentially limitless backwardation.

🚨 While the LME now has rules on day-over-day (tom-next) backwardations, 𝘁𝗵𝗲𝗿𝗲’𝘀 𝗻𝗼 𝗹𝗶𝗺𝗶𝘁 𝗼𝗻 𝗺𝗼𝗻𝘁𝗵-𝗼𝘃𝗲𝗿-𝗺𝗼𝗻𝘁𝗵 𝗯𝗮𝗰𝗸𝘄𝗮𝗿𝗱𝗮𝘁𝗶𝗼𝗻𝘀.

Yes, sophisticated trading desks at large traders maximize profits by actively trading both nearby and long-dated spreads, leveraging both long and short positions. But for most companies, the safest approach is simple: 𝗯𝗼𝗿𝗿𝗼𝘄 𝗲𝗮𝗿𝗹𝘆, 𝗯𝗲𝗳𝗼𝗿𝗲 𝘁𝗵𝗲 𝗱𝗲𝗰𝗶𝘀𝗶𝗼𝗻 𝗶𝘀 𝗳𝗼𝗿𝗰𝗲𝗱 𝘂𝗽𝗼𝗻 𝘆𝗼𝘂.