Thread by @profitsplusid

1/ Ever wonder how Commodities melt up in price? Or How prices of #Gold and #Silver blowout between New York and London? #LME

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2/ For many buying physical #preciousmetals, the London price is the primary market for pricing transactions. Although the New York Commodity Exchange (#COMEX) is widely reported and publicly available, this is a derivatives market

3/ How these markets differ can be defined by their users. London’s market provides a pricing mechanism for the physical investor, producer, user, fabricator, etc around the world. The Comex was designed as a hedging market.

4/ The primary focus of the Comex is allow the physical investor, producer, user, fabricator a forum to hedge existing or forward inventories.
By design, the Comex allows a high degree of leverage to help offset carry costs of hedgers.

5/ On the flip side, this leverage allows speculators to bet on price direction with little upfront capital. Speculator’s primary intent is to capture short term profits in price volatility.

6/ By design, the Comex is a seller’s market. This is due to the fact that hedging activity is dominated by large capital pools or financial institutions. The Comex does provide a process to stand for delivery, however,

7/ the seller of the contract controls whether they want to deliver metal to the exchange or close/roll the contract forward.
When volatility increases due to liquidity constraints, a number actions begin to happen.

8/ These actions can lead to an event where pricing in New York and London widen considerably. Without getting into options and the possible effects of delta hedging and gamma have on the underlying position, we will focus on basic structure.

9/ When markets initially experience volatility, players try to reduce position size to reduce exposure. When a producer opens a position on the futures market, many times it is for hedging their production or inventory.

10/ The intent is to reduce price volatility in their business. A miner pulls gold out of the ground for $1500, however, to finance that effort, they may sell that production to settle at a future date. Hence, they short a futures contract.

11/ This involves leverage because they are borrowing a small amount of money to control a larger nominal position.

As market volatility picks up, more players may feel the need to protect their revenue by locking in forward prices.

12/ However, the flip side to this is when investors see the same volatility and begin to buy the gold for its risk haven qualities or profit potential. All of a sudden price of the commodity begins to rise.

13/ Hedging positions which were sold at stated price begin losing value and require more capital to maintain the margin position. The hedger may very well have the product to deliver against, however it may not be available for delivery to deliver against the existing short.

14/ This forces the producer to close or roll the contract. This creates a buy transaction on the Comex. This adds to the upward price pressure. Prices begin to widen versus London due to the additional buying pressure from hedgers or shorts on the Comex market specifically.

15/ It is important to note that widening spreads are not the same as #backwardation. Widening spreads could be higher physical demand or purely the squeeze on paper shorts. We can see widening spreads between London and Comex yet still be in #contango.

16/ Whereas backwardation is more indicative of rising physical demand for immediate delivery. Today’s price is more expense than a futures’s contract 3 months out for example.

Keep in there are many other factors that influence spreads and futures price structure.

17/ At some point, an #arbitrage opportunity exists where, other players can deliver and sell their metal on the exchange for a better price than London. This eventually helps ease the spread between London and Comex.

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