Hedging with Jorge #Episode 59: How premium differentials drive aluminium trade profits

In this insightful episode of Hedging with Jorge, we explore a real-world example from the aluminium trade, an example that highlights the subtle yet powerful role of premiums and hedging strategies when prices rise.

Jorge walks us through a familiar trading scenario: you’ve already purchased aluminium at $2,500 per tonne, inclusive of a physical market premium. However, your customer agrees to take the material only later, fixing the price on the third Wednesday of July. That sets the stage for a pricing mismatch, which, if unhedged, could expose your margin to market volatility.

To mitigate this risk, Jorge illustrates the logic of establishing a short hedge using futures contracts, locking in the sale price at $2,506, assuming a contango market with a $6 spread. This way, you’re safeguarded from downward price movements, but what happens when prices move in the other direction?

Jorge examines just that: a scenario where aluminium prices increase to $2,600 by the time your customer is ready to fix the price. You invoice the customer at $2,600 + premium, generating a gain of $100 on the base price. But simultaneously, your futures hedge results in a $94 loss because you had to buy back your position at a higher price than you sold. Net result: a $6 gain, plus any differential in physical premiums.

The key takeaway?

With futures, your price is locked in. While it protects you from downside, it also limits your upside. In this case, the market moved in your favour, but your hedge absorbed most of that gain.

So, is there a way to retain upside potential while staying protected?

Yes, through the use of options, specifically put options. Jorge introduces the idea of purchasing a put option instead of shorting futures. This offers price protection if the market falls, while still allowing full participation in price increases. It’s a powerful tool for traders who want flexibility without sacrificing security.

To summarise:

• Futures lock in your economics, but cap your upside.
• Options require a premium cost, but enable you to benefit from rising markets.
• Premium differentials in physical aluminium continue to be a central source of profit.

In conclusion, Jorge encourages viewers to visualise the numbers and re-watch the episode for clarity. As always, the blend of market insight and clear explanation makes this episode a valuable resource for industry professionals navigating price volatility.

Stay tuned for the next episode, where Jorge will further explore how to harness option strategies in real trading scenarios.