Buying (Going Long) Aluminum Futures to Profit from a Rise in Aluminum Prices

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Contents

Buying (Going Long) Aluminum Futures to Profit from a Rise in Aluminum Prices

If you are bullish on aluminum, you can profit from a rise in aluminum price by taking up a long position in the aluminum futures market. You can do so by buying (going long) one or more aluminum futures contracts at a futures exchange.

Example: Long Aluminum Futures Trade

You decide to go long one near-month LME Aluminum Futures contract at the price of USD 1,470 per tonne. Since each LME Aluminum Futures contract represents 25 tonnes of aluminum, the value of the futures contract is USD 36,750. However, instead of paying the full value of the contract, you will only be required to deposit an initial margin of USD 4,375 to open the long futures position.

Assuming that a week later, the price of aluminum rises and correspondingly, the price of aluminum futures jumps to USD 1,617 per tonne. Each contract is now worth USD 40,425. So by selling your futures contract now, you can exit your long position in aluminum futures with a profit of USD 3,675.

Long Aluminum Futures Strategy: Buy LOW, Sell HIGH
BUY 25 tonnes of aluminum at USD 1,470/ton USD 36,750
SELL 25 tonnes of aluminum at USD 1,617/ton USD 40,425
Profit USD 3,675
Investment (Initial Margin) USD 4,375
Return on Investment 84%

Margin Requirements & Leverage

In the examples shown above, although aluminum prices have moved by only 10%, the ROI generated is 84%. This leverage is made possible by the relatively low margin (approximately 12%) required to control a large amount of aluminum represented by each contract.

Leverage is a double edged weapon. The above examples only depict positive scenarios whereby the market is favorable towards you. If the market turn against you, you will be required to top up your account to meet the margin requirements in order for your futures position to remain open.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

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Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Buying Aluminum Call Options to Profit from a Rise in Aluminum Prices

If you are bullish on aluminum, you can profit from a rise in aluminum price by buying (going long) aluminum call options.

Example: Long Aluminum Call Option

You observed that the near-month LME Aluminum futures contract is trading at the price of USD 1,470 per tonne. A LME Aluminum call option with the same expiration month and a nearby strike price of USD 1,500 is being priced at USD 98.00/ton. Since each underlying LME Aluminum futures contract represents 25 tonnes of aluminum, the premium you need to pay to own the call option is USD 2,450.

Assuming that by option expiration day, the price of the underlying aluminum futures has risen by 15% and is now trading at USD 1,690 per tonne. At this price, your call option is now in the money.

Gain from Call Option Exercise

By exercising your call option now, you get to assume a long position in the underlying aluminum futures at the strike price of USD 1,500. This means that you get to buy the underlying aluminum at only USD 1,500/ton on delivery day.

To take profit, you enter an offsetting short futures position in one contract of the underlying aluminum futures at the market price of USD 1,691 per tonne, resulting in a gain of USD 190.00/ton. Since each LME Aluminum call option covers 25 tonnes of aluminum, gain from the long call position is USD 4,750. Deducting the initial premium of USD 2,450 you paid to buy the call option, your net profit from the long call strategy will come to USD 2,300.

Long Aluminum Call Option Strategy
Gain from Option Exercise = (Market Price of Underlying Futures – Option Strike Price) x Contract Size
= (USD 1,690/ton – USD 1,500/ton) x 25 ton
= USD 4,750
Investment = Initial Premium Paid
= USD 2,450
Net Profit = Gain from Option Exercise – Investment
= USD 4,750 – USD 2,450
= USD 2,300
Return on Investment = 94%

Sell-to-Close Call Option

In practice, there is often no need to exercise the call option to realise the profit. You can close out the position by selling the call option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the aluminum option sale will be equal to it’s intrinsic value.

Learn More About Aluminum Futures & Options Trading

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Long Hedge

What Is a Long Hedge?

A long hedge refers to a futures position that is entered into for the purpose of price stability on a purchase. Long hedges are often used by manufacturers and processors to remove price volatility from the purchase of required inputs. These input-dependent companies know they will require materials several times a year, so they enter futures positions to stabilize the purchase price throughout the year.

For this reason, a long hedge may also be referred to as an input hedge, a buyers hedge, a buy hedge, a purchasers hedge, or a purchasing hedge.

Understanding Long Hedges

A long hedge represents a smart cost control strategy for a company that knows it needs to purchase a commodity in the future and wants to lock in the purchase price. The hedge itself is quite simple, with the purchaser of a commodity simply entering a long futures position. A long position means the buyer of the commodity is making a bet that the price of the commodity will rise in the future. If the good rises in price, the profit from the futures position helps to offset the greater cost of the commodity.

Example of a Long Hedge

In a simplified example, we might assume that it is January, and an aluminum manufacturer needs 25,000 pounds of copper to manufacture aluminum and fulfill a contract in May. The current spot price is $2.50 per pound, but the May futures price is $2.40 per pound. In January the aluminum manufacturer would take a long position in a May futures contract on copper.

This futures contract can be sized to cover part or all of the expected order. Sizing the position sets the hedge ratio. For example, if the purchaser hedges half the purchase order size, then the hedge ratio is 50%. If the May spot price of copper is over $2.40 per pound, then the manufacturer has benefited from taking a long position. This is because the overall profit from the futures contract helps offset the higher purchasing cost paid for copper in May.

If the May spot price of copper is below $2.40 per pound, the manufacturer takes a small loss on the futures position while saving overall, thanks to a lower-than-anticipated purchasing price.

Long Hedges vs. Short Hedges

Basis risk makes it very difficult to offset all pricing risk, but a high hedge ratio on a long hedge will remove a lot of it. The opposite of a long hedge is a short hedge, which protects the seller of a commodity or asset by locking in the sale price.

Hedges, both long and short, can be thought of as a form of insurance. There is a cost to setting them up, but they can save a company a large amount in an adverse situation.

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