13.1 - Sumitomo Copper scandal

If you have any connection to the commodity market, this is the story you should have heard about - "The Sumitomo Copper Scandal". The scandal occurred in Japan around 1995. However, the impact it had on the commodity trading industry was felt throughout the world. It's so well-respected that it is still talked about today.

Sumitomo Corporation, a large conglomerate, was incorporated in Japan and is listed on the Japanese Stock Exchange. It is involved in the general trading of commodities and goods. Sumitomo used to have a large copper trading division back in those days. Sumitomo's copper trading consisted of buying copper on the spot market and physically placing them in its warehouses. Sumitomo also had large exposure to copper futures trading on the London Metals Exchange. Sumitomo's Chief Copper Trader was Yasuo Hmanaka. Sumitomo's chief Copper Trader was he.

Here's what happened:

• Yasuo Hmanaka purchased copper in its physical form (spotmarket) and stored them in warehouses.
• He purchased copper from Japan and kept it in different places/ports.
• He was basically long copper in spot market.
• The spot market exposed him to 5% of the world's outstanding copper reserves. He was, at that time, probably the only person on the planet to have so much copper. He was able to control copper's prices, literally.
• He also purchased Copper Futures at LME.
• Everyone knew Yasuo Hamanaka had been a copper bull. But, nobody knew how much he was exposed (LME didn't publish open interest data at that time).
• Hamanaka bought copper whenever traders or trading companies needed it. Because Sumitomo had cash and could finance these trades, he could buy.
• Copper prices rose because he purchased large quantities of copper.
• Copper is an international commodity and its price is determined by market forces (LME futures).
• LME prices rose, short traders were squeezed and Hamanaka made profit on futures.
• Short traders would default eventually, meaning they would have to deliver copper after expiry.
• These traders would invariably end up buying copper at a premium from Sumitomo, which meant Sumitomo also minted sharp profits on their spot positions.
• The profits soared and Yasuo Hmanaka was undisputed copper king.

This setup worked well for more than a decade. China increased its copper production in the 90s to the point that they oversupplied the market. The prices began to drop and Yasuo Hmanaka felt the heat. He was buying the bulk of the contracts, so it was hard for him to sell them. To keep his long positions, he borrowed money. These were all leveraged positions and a small loss can be caused by a large number of them.

This was exactly what happened: copper prices plummeted and Yasuo Hmanaka's copper kingdom fell. Sumitomo Corporation declared bankruptcy due to mounting losses. In 1995, the sum of all losses was close to $5 billion!

The next stage was the usual blame games, lawsuits and denials that followed, as well as all the drama. The key message from this story is that it emphasizes the importance ofrisk management. This topic will be covered in a separate module.

Let's get on with the copper basics.

13.2 - Copper Basics

Copper is a common base metal and is highly traded on MCX. If metal isn't precious like silver or gold, it is considered a base metal.

An average of 55,000 lots, the daily traded value is approximately INR 2,050 crores. Copper on MCX is a highly liquid contract. The liquidity is comparable to that of crude oil or gold.

Copper is an exciting metal. Copper is the third most commonly used metal, after aluminium and steel. Global economics directly affect the price of copper, much like that of aluminium. Copper is a great conductor of electricity. As such, it is the preferred metal for electrical wires. Did you know that the Tesla hybrid car's core has a copper motor, as opposed to a regular engine motor (permanent magnetic motor)?

Copper can also be used in many other applications, such as -

• Construction and building
• Copper alloy moulds
• Electronics and electrical
• Plumbing solutions
• Industrial uses
• Telecom
• Railways

My favorite use of copper is this.

This is what you should be able to guess. You and I may have a shared interest if you can guess. J

Similar trends to aluminium can be seen in the demand-consumption of copper. Take a look at the snapshot

The global demand for refined copper in 2015 was 24 million tonnes. Half of that demand came from China and Japan. The demand was greater than the supply (see the two bars to the right). However, due to the recent commodity glut the price has significantly cooled over the past few years.

While it is important to have a good understanding of the fundamentals, charts are what I use to trade copper. Let's now focus on the contract specifications. Both copper and aluminium have two contracts: the big copper contract, and its smaller version. Let me give you the details of the big copper contract.

• Price Quote - Per kilogram
• Lot Size - 1 metric Ton
• Tick size – Rs.0.05
• Profit &Loss per tick - Rs.0.05 * 1000 = Rs.50/-
• Expiry - Last day of the month
• Delivery units - 10 Mt

Here's a quick quote on copper expiring in February 2017.

As per the above, the price is Rs.389.1/kg. Accordingly, the contract value would be -

Lot size * Price

= 1000 * 389.1

=Rs.389 100/-

Below is the NRML margin.

This works out at 7.8%. This is the MIS margin.

Copper Mini contracts have a smaller lot size which means that there is less margin and P&L per tick.

• Price Quote - Per kilogram
• Lot Size - 250 Kgs
• Tick size – Rs.0.05
• P&L per tick - Rs.0.05 * 250 = Rs.12.5/-
• Expiry - Last day of the month
• Delivery units - 10 Mt

Technical analysis is a great tool to trade copper and other commodities. They are great for liquid commodities like copper. To get started, you will need to have the contract details.

Moving on to Aluminium!
 

13.3 - Aluminium Basics

Our goal is to provide basic information. This is because most people would trade this commodity in a holding period of no more than 2 days. It makes sense to focus on the price dynamics and not the fundamentals when this is the goal. For simplicity, the highlights of each chapter will be presented in bullet points. We will then dive deeper into the contract specifications.

Talk about Aluminium, and you're likely to think of the thin, silvery foil that wraps leftover food in your fridge. Aluminium has many other uses.

These are some things that you should know (have gathered this information from different online sources).

1. Aluminium is abundant (supply is not an issue). Around 8% of the Earth's crust is made of Aluminium. Aluminium is the third most abundant element after silicon and oxygen.
2. Aluminium is a highly desirable metal because it resists corrosion.
3. Aluminium manufacturing is energy-intensive. It takes 17.4 megawatts of power to produce 1 metric ton. This is how it looks
   

This is Hindalco's power and fuel costs. As you can see, almost 10% of the cost is for power and fuel. Hindalco also has its own captive power units. This power would be consumed above and beyond what Hindalco generates internally.

1. Recycling aluminium is an easy task. Recycling aluminium requires only 5% of the energy required.
2. Aluminium can be used in many different ways, from smartphones to Boeing 747s. Did you know that a Boeing 747 can use approximately 70,000 kilograms aluminium?
3. Aluminium can also be used in other industries, such as automotive, building and construction, defense, electronic, pharmaceuticals and white goods.
4. Aluminium is one of the metals that has both abundant supply and high demand.
5. The MCX aluminium prices closely follow the international aluminium prices which are traded on the London Metal Exchange.

Here is a snapshot that shows you the trends in supply and production as well as the average price for aluminium on LME.

This chart is fascinating. It can even be used to formulate some basic trading principles. Let's take this graph and break it down into smaller pieces.

1. In 2015, the global production (blue bars) of aluminum was 56 million tonnes. This is an increase of approximately 4% over the previous year.
2. Global production has experienced a 6% CAGR over the past 8 years.
3. The demand (yellow bars) on the opposite side is equal to global production. This means that there are no disruptions to supply and demand.
4. Actually, over the years, both supply and demand have remained relatively stable.
5. Aluminium's price has fallen over the past few years. The average price of aluminium is $1,500/ton, which is down from the $2,500/ton peak. The global commodity glut is something you must have heard. The global aluminium pricing is influenced by the Chinese demand.
6. In percentage terms, the Indian demand is higher than the global demand. Hindalco claims that India has a demand of approximately 2 million tonnes for aluminium. Importing aluminium is a major source of this demand.

These basic points should be enough to get you started with Aluminium fundamentals. However, technical analysis is what I prefer to use for trading aluminium. This is due to my relatively short holding time, which usually only lasts a few trading sessions.

With that, let's move on to contract specifications. This will allow you to understand the practicalities of trading aluminium on MCX.

13.4 - Specifications for Aluminium contracts

You may have guessed that there are two major aluminium contracts you can trade on MCX. These are the big and small aluminium contracts. Both differ in the amount of lot and contract value. First, we will talk about the large aluminium contract.

The average daily traded value for big aluminium is approximately INR 375 Crore. The volume can reach INR 500 crores on a good day. The value of the commodity isn't as high as that of commodities like crude oil and gold, as you might have realized.

These are the contract details:

• Price Quote - Per kilogram
• Size of lot - 5 metric tons

This contract is quite large, so you might have realized it. 5MT is a metric ton, which is 1000 kg. The price is per kg and the lot size is 5500 kgs. Each tick will result in a P&L at Rs.5000/- provided the tick is Rs.1/+. This would be prohibitive, especially for retail trading. MCX has therefore reduced the tick size to Rs.0.05. Rs.0.05

• Tick size – Rs.0.05
• Profit &
  P&L per tick - Rs.0.05 * 1000 = Rs.50/- Loss per tick - Rs.0.05 * 5000 = Rs.250/-
• Expiry - Last day of the month
• Delivery units - 10 Mt

Let's look at this information more closely. Aluminium quoted on MCX on a per-kilogram basis. Take a look below at the picture to see the market depth of Aluminium.

You can see that the price of aluminium expiring Dec 2016 is Rs.118.4/kg

TheLot size: 5 MT (5000kgs).This means that if you are looking to buy or go long on Aluminium, the value for such a contract is -

Lot size * price quote

= 5000 *118.4 (offer price for going long)

=Rs.592,000/ -

Aluminium's price movement is 0.05. This means that if aluminium moves between 118.4 and 118.45, then the profit will be -

118.45 -118.4

=0.05

=0.05*5000

=Rs.250/

The NRML margin is charged at Rs.33 719/-, which works out to 5.6%. The MIS margin is nearly half the NRML margin.

Below are the contact details for Aluminium mini-

• Price Quote - Per kilogram
• Lot Size - 1 metric Ton
• Tick size – Rs.0.05
• Profit & Loss per tick - Rs.0.05 * 1000 = Rs.50/-
• Expiry - Last day of the month
• Delivery units - 10 Mt

The contract value is very small.

= 1000 * 118.4

=Rs.118.400/-

NRML margin is Rs.6,779 /-,,, which is 5.7%. The margin for MIS is less at Rs.3,389, or 2.8% of contract value.

P&L per tick is Rs.50/–, which is a much more 'deal-able" value while trading.

This information should be enough to help you get started with trading Aluminium. You need to examine the chart and develop a point-of-view before you can place trades based upon the chart pattern.

To Summarize

1. Base metals include both Copper and Aluminium
2. Aluminium can be found in abundance, just like silicon and oxygen.
3. It seems that the demand-consumption ratios for copper and aluminium are in some sort of equilibrium.
4. Over the years, both copper and aluminium have seen their prices decline.
5. These international commodities are referenced by the prices of copper and aluminium on the London Metal Exchange (LME).
6. Copper and aluminium both have two contracts: the big one, and the mini.
7. Contract sizes and margins can vary depending on the contract.