Copper Options Signal Uncertainty

AT-A-GLANCE

• Copper options traders see somewhat more elevated risk for the metal than they did pre-pandemic
• Copper options have a mildly negative skew with OTM puts costing more than OTM calls as of early June
• More negatively skewed copper options have sometimes implied better-than-average price returns for copper going forward

Copper prices surge by 148% between its low in March 2020 and high in May 2021 powered by a global manufacturing boom resulting from a lockdown-induced shift in consumer spending towards durable goods. There was additional support from stimulus measures boosting consumer demand. Since May 2021, copper prices have mostly traded sideways (Figure 1).

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Figure 1: Copper prices rose 148% from March 2020 to May 2021, then traded sideways

Often when markets lack a strong directional trend, implied volatility in options will begin to decline. That hasn’t been the case for copper options in the past 12 months. In the two years before the pandemic struck, implied volatility on one-month (1M) at-the-money (ATM) copper options traded in a historically low range from 13.8% to 24.7%. In the early stages of the pandemic, implied volatility rose as high as 49% on 1M ATM copper options. In the past year, even as copper prices moved sideways, implied volatility has settled into a range from 22.5% to 33.6% -- this range is about 1.5x as high as the pre-pandemic range for copper options (Figure 2).

Figure 2: Copper option implied volatility has been in a higher range than in 2018 and 2019.

Copper options traders’ view of market risk may reflect the greater-than-usual uncertainty that surrounds the copper market in the aftermath of the pandemic. Points to ponder include:

• Will consumers shift their spending away from durable goods and back to services? If so, how will it impact demand for copper?
• How will higher mortgage rates in Europe and the U.S. impact the pace of housing construction, given that each home contains, on average, 220lbs/100kg of copper?
• Will the energy transition continue to boost demand for copper, and at what pace?
• What impact will potentially slower growth in China have on copper demand?

While copper options currently suggest an elevated risk of large price moves compared to the years immediately prior to the pandemic, there doesn’t appear to be much of a consensus among options traders as to whether the most extreme risks are to the upside or downside. To examine whether options traders fear extreme upside or downside risk, we look at the so-called risk reversal: the difference in the implied volatility on out-of-the-money (OTM) copper calls and puts that are 0.15 standard deviations from the ATM price. When OTM call options cost more than equivalently OTM put options, it’s an indication that traders are more concerned about extreme upside risk than extreme downside risk of the underlying instrument. The opposite is true when OTM put options cost more than similar OTM calls.

Over the past 13 years, copper options traders have more often priced a greater extreme downside risk than extreme upside risk. This was the case during much of the period from 2013 to 2016 and again in the early stages of the pandemic. This has not, however, always been the case. In the early stages of the recovery from the global financial crisis, copper options often reflected a perception of a positive skew to risks, and the same was true during the economic expansion during the later part of the 2010s (Figure 3).

Figure 3: Risk reversal skew on copper options implied volatility has been negative in recent weeks

This raises the question of whether skew in copper options has any bearing on future price movements in the metal? To answer, we created a diffusion index which ranks the current level of implied volatility on copper options on a scale from 0 to 100 based on its past two years of implied volatility. If, for example, copper options are the most negatively skewed in two years, the diffusion index would have a reading of zero. By contrast, if the copper options risk reversal was at the most positive skew that it had been at any time over the past two years, the index would have a reading of 100. If the risk reversal was exactly at the average of the past two years, the index would have a reading of 50.

In recent weeks the two-year rolling diffusion index for copper options risk reversal has been in the range from 10-20, implying that only 10% to 20% of the time during the past two years were copper options more negatively skewed than they have been recently (Figure 4). 

Figure 4: Only 10% of the time over the past two years has the copper options skew been more negative than it is currently.

But what might this mean for the price of copper going forward? Over the past dozen years, copper prices have more often than not moved in the opposite direction of what the risk reversal suggested was most likely. In short, the risk reversal skew has shown some tendency to be a contrary indicator. For example, when copper options suggested that there was a much greater chance of an extreme downside rather than upside risk, copper prices more often rose over the next three months. This was the case early in the pandemic when copper prices initially fell, triggering concerns about extreme downside risk, only to see prices more than double from their lows. By contrast, when copper traders are most concerned about extreme upside risk relative to extreme downside risk, copper has historically been more vulnerable to subsequent price declines (Figure 5). 

Figure 5: Copper tends to underperform when options traders are most concerned about extreme upside risk

As such, the fact that copper options traders tend to fear extreme downside risk more than extreme upside risk should not be taken as a suggestion that copper prices are more likely to fall than to rise over the coming months. Indeed, we cannot predict prices, and one could argue that the opposite might be more likely. 

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