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The jump in volatility will be welcomed by the exchange. Much of 2016 has been characterised by prices bumping along the bottom in quiet, low volume trading conditions.
This all changed in the fourth quarter. November’s surge in volumes was attributed to the increase in speculator activity which started in China as hot money moved out of property and equities and into commodities. The shift was contagious and western funds jumped on board too.
This coincided with promises from US President-elect Donald Trump to increase infrastructure spend, alongside more positive sentiment emanating from LME Week in London.
November business on the exchange reaped the rewards and total LME average daily volumes (ADV) were up 4.6% year-on-year.
Copper was the biggest beneficiary; its ADV were up 16.8% year-on-year. LMEselect daily volumes hit a record high as more than 72,000 lots of three-month copper changed hands on November 14, while 351,411 lots of copper traded on November 11 across the LME platforms – the highest since January 14, 2015.
Still, total business across the six base metals was down 7.9% in the first eleven months of the year.
For the exchange to match 2015’s full-year total volume of 169 million lots, December would need to see 26 million lots traded.
Open interest was also down year-on-year as it fell 4.7% during January-November, and down 1.9% in November.
Against this backdrop, LME executives had to fend off questions from disgruntled participants as to why its business was falling at a time when its competitors – such as the USA’s CME – was posting increases.
The exchange attributed it to a weak economic environment and a downturn in physical activity. Market participants, however, pointed the finger at higher fees pushing traders towards cheaper alternatives.
CME copper volumes in November reached 3,531,273 contracts, up 91.5% year-on-year. Its daily volume record was broken three times in November, the strongest of which was 332,467 contracts on November 11. Month-end open interest was up 34.2% year-on-year at 240,760 contracts.
“There is life in the old metals dog yet – November was exceptional, but next year and beyond I expect a continuation of that environment and metals trading will become a lot more interesting,” a senior category I source said.
Surges a sign of speculative activity However, some LME members cautioned that the November rise should not be attributed to “everyone wanting to trade the LME again” but rather that the exchange was benefiting from the speculative activity.
December business has been far quieter than in the previous month as the love-affair from specs waned, although prices have remained choppy.
As the start of 2017 approaches, there is likely to be further volatility ahead, partially due to activity around the options market.
“Things are structurally shifting. There was a lot of short options that had to cover the negative gamma, and while that has gone for now trading activity is up. The volatility will remain next year and this will be good for volumes,” another senior category I member said.
November’s surge in volatility was a key example of what can happen when high-frequency trading (HFT) and commodity trading adviser (CTA) traders get involved.
Price moves were swift and intraday price ranges were large: on November 11, copper noted a high-to-low ratio of more than $500 when it broke above $6,000 per tonne.
As the market moved out of range, it caught out option hedgers – many of which had been short volatility. When this happens and volatility spikes, the rate at which holders have to hedge rises; an investor must buy back a long position on the futures market to hedge against its position.
Unsurprisingly, not everyone welcomed a more volatile price environment. The large price swings resulted in many investors being called for margins.
In volatile trading conditions, traders can be called for additional margin to keep positions open.
“The volatility created margin calls and that puts business under pressure. This leaves you with the dilemma on if you should hedge or not. The price volatility created a squeeze on capital and that is not taken lightly,” Lion Consultancy’s Michael Lion said.
Increased HFT participation Others said that the increase in participation of HFT distorted the ‘true’ market as the daily range in prices can be substantial and algos can trade far quicker than a human.
“Sure HFT generates more fees for the exchange but it can be detrimental to volatility and the pricing is not true – then there is the whole issue of it being seen as legalised front running,” a third senior category I member said.
“You have to ask if it creates the right liquidity – it creates more risk and makes it difficult to hedge and for dealers to manage price exposure,” he added.
Indeed, some participants may question their appetite for risk due to the continued huge intraday/week ranges and the associated cost of staying with a position, Kingdom Futures’ Malcolm Freeman said.
“This in effect leaves the funds and the now much reviled high frequency/algorithmic systems to ‘play’ on their own,” he concluded.