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This Learning Curve seeks to describe some of the unique features of London Metal Exchange options to a practitioner familiar with options, but new to the LME options market. It also gives some examples for trading that are commonly used in the base metals market for hedging and speculative purposes.
The Base Metals Options Market
There are a number of factors that distinguish LME options from more traditional derivatives:
Term structure: the future price of any commodity is inherently linked to the physical market. As a consequence the'cost of carry' is a fundamental driver of the future value of any base metal. A host of factors influence the cost of carry and the overall term structure including interest rates, insurance costs, and storage costs in addition to the impact of supply and demand for the metal. This is in contrast to other financial markets where the forward price is predominately a function of an interest rate differential.
Standardized strike increments: When transacting an at-the-money LME option, the strike will be determined by reference to the underlying futures price and will be set at the nearest increment to the traded month's futures price. The standardised increments for aluminium, copper, zinc and lead are $25 and $100 for nickel and tin. Note that these increments do shift given significant changes in the value of the underlying metals futures price. However for all practical purposes the increments detailed are appropriate given current market dynamics.
Definition of the volatility surface: the market trades in pre-defined strike increments and consequently constructing a surface is complex. More specifically, commonly used delta points e.g. 10, 25 and 40 delta which trade in other...