November/December 1988
Take a look inside New York’s Commodity Exchange and you may want to run for cover. But amid the madness are high-stakes trades that affect your business. Here to help you get a handle on how COMEX works is an explanation of the exchange.
By Si Wakesberg
Si Wakesberg is a New York City-based consultant to the Institute of Scrap Recycling Industries.
Drop a stranger into the pit where a COMEX trading session is in progress, and he might imagine he'd wound up in Alice's Wonderland. All sides of the scene are bewildering, with a crescendo of outcries that only the most sensitive ear can convert into appeals for the buying and selling of commodity contracts.
But to the traders, the floor brokers, and the regulars intently watching for prices on their computer screens, this is a typical day of business--a business in which millions of contracts change hands each year, in which millions of dollars are involved, and where prices flash like neon signs for the world metals industry.
Formally known as Commodity Exchange, Inc., COMEX is a futures commodities exchange; that is, a market where contracts for future purchases and sales of various commodities are transacted by auction. Begun during the
Depression in 1933 on New York's Broad Street, COMEX moved in mid-1977 into the World Trade Center, where it shares space with four other exchanges.
COMEX currently trades in gold, silver, copper, and aluminum, as well as in options for gold, silver, and copper. Options on futures differ from futures contracts in that an option is the right--but not the obligation--to buy or sell a futures contract at a specified price on or before a specified date. The buy is a "call" and the sell is a "put."
To give you an idea of how much trading transpires: More than 10 million contracts in gold were traded in 1987; a little more than 5 million contracts were traded in silver. Options contracts for all three metals totaled close to 3 million. Overall trading on the exchange has grown phenomenally in the past 20 years. In 1970, for example, the total volume of all contracts was 900,000. Last year, trading skyrocketed to over 21.5 million contracts, including trading in gold, copper, silver, and aluminum futures, as well as in options.
All trading takes place on the exchange floor in areas known as rings or "pits." Trading hours differ for the various metals--for example, copper is traded from 9:25 a.m. to 2:00 p.m. All transactions are made through brokers, who are paid a commission to buy or sell orders. Those who execute orders on the exchange floor are known as floor brokers, while those who handle retail customer orders are known as upstairs brokers or account executives. Some floor traders, known as "locals," execute transactions for their own accounts only.
Contract sizes are specified but vary among different metals. For example, the copper contract specifies 25,000 pounds, the aluminum contract, 40,000 pounds. (A new, upgraded aluminum contract for September 1989 specifies 44,000 pounds.) COMEX calls for specific delivery months, as far out as 23 months, and there is the spot month. (A spot month is the first deliverable month in which a quote is available.)
There are now 772 seats on COMEX. Members range from metals firms to large banks, major investment and brokerage houses, and individuals--all of whom must meet the capital requirements of the exchange. The price of a COMEX seat soared from about $7,500 in 1970 to $350,000 in 1980. It underwent considerable fluctuations in the succeeding years, and today is around $137,000.
It might be pointed out that copper, aluminum, and silver are also traded on the London Metal Exchange (LME), which also trades in lead, zinc, and nickel. The existence of an exchange like the LME affords traders in the United States the chance, at times, to take advantage of the difference that may exist in prices on COMEX and the LME.
Hedging: A Vital Exchange Tool
Hedging is often given as the principal raison d'etre for exchange activity. In a sense, hedging is seen as a way to insure against market risks and to protect the hedger against the violent fluctuations of the market. To hedge is to establish a position in the futures market that is equal to and opposite from a position held in the physical, or cash, market.
For example, a copper fabricator knowing that he will need, say, X amount of copper three months from now may choose to purchase, today, an equivalent amount of copper in the form of futures contracts. If copper prices rise, his gain in the futures market over three months' time likely will be offset by the higher prices for physical copper that he will buy in three months. Conversely, if copper tags fell over the period, his losses in the futures market will be offset by the lower prices he likely would have to pay in the physical market for copper.
In this instance, he has "insured" his price by establishing opposite positions in the physical market and the futures market. A loss in one is offset by a gain in the other.
What the fabricator has done in this classic "buy hedge" example is offset the risk of market fluctuation. Other examples along these lines can also be given. Says a COMEX executive, "The fact that exchanges permit opportunities for hedging is of great benefit to the metals industry ... and to the overall economy."
There is plenty of evidence that large metal producers (among whom are some who shunned the exchanges in the past) are now participating in the futures markets in one way or another. Some are using COMEX (or LME) prices as a base for their own prices. Others engage in hedging operations.
Some scrap prices, such as No. 1 copper scrap and No. 2 copper scrap, have long been tied to COMEX prices. While, generally, these scrap prices have been at a discount to the COMEX price, there have been periods in metals history when the price of No. 1 copper, for instance, has been higher than the COMEX spot price. This resulted because primary copper was in a squeeze and was unavailable (due to strikes or other reasons) and scrap copper became more valuable.
Questions continue to be raised about the value of hedging operations. But most metal analysts agree that hedging is a vital tool for the metals industry, providing a means of reducing risk in buying and selling commodities.
The Role of Speculators
What about speculators--those who do not engage in hedging but take chances on a commodity's rise or fall? In a nutshell, speculators are those who make decisions to buy or sell a metal based on their estimates of the metal's future supply, demand, inventory, and price positions. They do not attempt to "insure" their investment but risk it on a hoped-for move of the market.
Speculators (some like to be called investors) try to gauge a market's direction by closely following economic barometers, by studying market trends, by charting prices over a period of time, by assessing a metal's demand/supply position, by analyzing inventory levels. What it all boils down to is that speculators are risk-takers. The more volatile the market, the better it is for the speculator. By taking chances, the speculator has an opportunity to do well if the market goes his way. On the other hand, if it goes contrary to his expectations, he stands to take a loss, sometimes a considerable one.
The feelings on the exchange regarding speculation are mixed. One COMEX official says that "speculators provide investment opportunities … they contribute capital and liquidity on the exchange." But some industry executives call COMEX a sophisticated gamble, a kind of Las Vegas.
To such criticism, COMEX President and Chief Executive Officer Alan Brody replies, "COMEX is not a speculative haven. We maintain records which reveal speculative versus nonspeculative activity and we find speculative activity at a level one would hardly call influential." He adds, "in fact, our records for last year show that generally 25 percent of the activity might be termed speculative; 25 percent was commercial, such as hedging and arbitrage; and 50 percent was local floor trading."
Taking Delivery
There's an old story about the naive chap who bought some grain contracts and forgot all about the delivery date. Three months later, a large procession of trucks pulled up in front of his Long Island estate and a truck driver jumped out and asked the startled investor, "Where do we dump all this grain?"
It's just a story, of course, since very few buyers of COMEX contracts ever expect to take delivery. According to the exchange, a study about six years ago showed that "less than 3 percent of all U.S. futures transactions resulted in actual delivery of the commodity underlying the futures contract."
Yet while COMEX may not see itself as a physical metal exchange, the fact is that, in times of poor market activity, material moves to the highest-priced market, which may be the "terminal" or exchange market--whether COMEX or the LME--and in times of squeezes, material is moved out of the exchange warehouses to meet industry needs. One can read the weekly changes in warehouse stocks (or in daily inventory reports) and see which way the market is heading. Taking delivery of COMEX copper, for example, could be a thwarting and aggravating procedure, metalmen say, as the buyer is faced with geographical problems, transportation matters, and insurance questions.
COMEX in the Coming Decade
"COMEX will continue its leadership in the North American copper market as we move into the 1990s," says Brody. He notes that "the majority of copper produced in the U.S. today is sold on the basis of the daily COMEX settlement price." He also foresees gains by COMEX in the world copper market. He hopes aluminum trading will catch fire and show growth in contract volume. As for gold and silver, COMEX is already the world's leading futures exchange, he said.
"Diversification is our goal as we approach the 1990s," Brody says, pointing to the remarkable growth of options trading, as well as plans for various new product projects currently in research. He forecasts greater utilization of such trading tools in the next decade.
COMEX has developed state-of-the-art technology for trade processing that, according to exchange officials, will result in major changes in the way business is transacted on the floor. One official says that the new system will be "the most automated in the futures industry."
Brody says he was realistic enough to anticipate a continuation of the cyclical movement in metals. Last year was a banner year for copper; this year, trading in copper has slowed down. He foresees heavier doses of regulations from government agencies, fluctuations in the dollar, and shifts in the economy. But, overall, he expects good demand for metals and a continuation of interest in all segments of the metals industry--whether gold, silver, copper, or aluminum, including options on these metals. Says Brody, looking ahead to the 1990s, "COMEX will grow and become a more vital and important exchange."
[SIDEBAR]
Copper a COMEX Star
COMEX gets excited about copper. Trading in this commodity showed such phenomenal growth that COMEX allocated a special pit for the metal. In 1987, the trading volume in copper reached 2.6 million contracts.
At the end of last July, COMEX began trading in a new high-grade (Grade 1) copper contract. A spokesman for the exchange points out that this change in contract was important because, "during the past 25 years, new technology of production and utilization has resulted in a growing demand for high-grade copper."
Today, most of the world's copper production is Grade 1. Under the new contract, only ASTM-certified Grade 1 electrolytic copper cathodes will be deliverable. The first delivery month for the new high-grade contract is January 1989. Says one COMEX official, "With the new high-grade contract, deliverable copper will be more consistent with the bulk movement of the metal in the copper industry." But when asked whether COMEX was trying to match LME contracts in copper, the spokesman replies, "It's not likely that there will be identical contracts on the exchanges, since we have somewhat different constituencies."
[SIDEBAR]
Aluminum Lacks Luster
COMEX officials admit a trend toward greater similarity with LME contracts, particularly in the new aluminum contract. Comments COMEX's vice president, research, J. William Hanlon, "The aluminum cash market trades mainly in the higher grade metal and for that reason we felt that it was necessary to change the contract specifications to reflect the realities of the marketplace." The revised aluminum contract, as of September 1989, will permit delivery of grade P1020A, and of primary aluminum of a minimum 99.7 percent purity, with a maximum iron content of 0.2 percent and a maximum silicon content of 0.1 percent. The size of the contract will increase from 40,000 pounds to 44,000 pounds.
Aluminum trading on COMEX has been disappointing. Only about 9,000 contracts were traded in 1987 and some industry sources say that the total may be much lower for 1988. Asked why aluminum trading--despite its dazzling market activity in 1987-1988--hadn't caught on, Alan Brody responded that "aluminum trading unfortunately opened at the top of the market, which then turned bearish ... and we haven't been able to get sufficient local trading to boost volume and make the market as pertinent to the industry as copper trading." Brody insists, however, that "we are not going to give up on aluminum. ... One of the first steps we've taken is to upgrade our contract, which should help in the eventual revitalization of COMEX trading in aluminum."
[SIDEBAR]
Some COMEX Terminology
COMEX-watchers should be familiar with certain common terms that are used in exchange circles and market reports.
Backwardation--When futures prices are lower than cash prices. Not a usual condition, though in 1988 it was apparent in a number of metals.
Contango--When futures prices are higher than cash prices. A more usual market condition.
Arbitrage--When a purchase is made in one market (like COMEX) against a simultaneous sale in a different market (like the LME) so that a profit can be realized from the difference in the two prices. Unless there is a fairly good differential between the two exchanges, the investor may hesitate to engage in arbitrage.
Long Position--A situation in which someone has purchased futures contracts or owns the actual commodity.
Short Position--A situation in which someone has sold futures contracts or has sold the actual commodity.
Straddle--The simultaneous purchase and sale of separate futures contracts for the same commodity, for delivery in different months. Also known as a "spread."
Warehouse Receipt--A document issued by an exchange-approved storage facility showing possession of a commodity.
Take a look inside New
York's Commodity Exchange and you may want to run for cover. But amid
the madness are high-stakes trades that affect your business. Here to help
you get a handle on how COMEX works is an explanation of the exchange.