By Andy Home/London

The copper market started the year with a bang. Over the course of just two days, January 13 and January 14, London Metal Exchange (LME) three-month copper slumped by over 11% to hit what was then a six-year low of $5,353.25 per tonne.
The bear raid was laid at the door of Chinese funds, turning the spotlight on previously obscure entities such as the wonderfully-named Shanghai Chaos group.
In truth, the severity of the blow-off was as much down to liquidity black holes. The Shanghai Futures Exchange copper contract went limit down and the overflow of sell orders hit the London market hours before most traders had switched on their systems.
In addition, layers of put options acted as a downside accelerator as option shorts tried to hedge their exposure to a rapidly falling price.
Options are a niche market within the niche market that is LME copper trading and few pay much attention to these ghosts in the trading machine until it is too late.
Which begs the question as to whether copper might end the year with a similar bang. Because put option open interest over the fourth quarter, particularly in December itself, is now higher than it was back in January.
Back in January the price collapse brought into play over 700,000 tonnes of downside options spread over the February-June period.
Holders of those options will have felt vindicated in taking out insurance against precisely such a bear sell-off. Sellers of those options, on the other hand, would have had to “delta-hedge” their exposure, adding an extra stream of selling to what was already an avalanche of sell orders.
This is how options work, sitting there dormant for long periods of time before switching into active mode as magnetic attractors in a fast-moving market. And there are a lot of put options lying dormant beneath the market over the next three months, a cumulative total of around 1.33mn tonnes with the largest component, 856,000 tonnes, in December.
That in itself is not unusual. Options open interest tends to be high at year-end in all the LME-traded metals.
What is unusual is the scale of the December copper positions, particularly those on three particular “big number” strike prices.
Market open interest on the December $5,000 strike is currently 7,167 lots (179,175 tonnes). That on the $4,500 strike is 7,388 lots (184,700 tonnes). And towering above everything, quite literally in the chart above, is the $4,000 strike with 10,899 lots (272,475 tonnes). There may be more.
It is in the nature of LME trading, particularly options trading, that what is visible on the exchange is the tip of a bigger over-the-counter iceberg.
Quite how big only becomes clear if those options are activated by a falling price. None of which is to say that the price must inevitably fall to those levels over the coming weeks and months, or that every option is an expression of expected direction.
Some of those options are undoubtedly speculative in nature with buyers eyeing copper’s downside potential.
But most of them are there as insurance policies, both for producers looking to protect themselves from further price falls and long futures position holders looking for a safety net in the event of another collapse.
And we know there is at least one big long futures position in LME copper. It’s there every day in the exchange’s market positioning reports  and it’s been there all year. Right now, it accounts for somewhere between 50 and 80% of all live LME stocks. There is another, smaller one as well, controlling between 30 and 40% of available tonnage.
It would be unusual, and highly risky, if such positions weren’t insured against the downside with put options an obvious part of the hedging tool-kit.
Whether you believe copper might fall as far as $4,000 by the end of this year will come down to whether you are a demand sort of guy or a supply sort of gal.
If you’re the former, you’re probably in the Goldman Sachs camp, which has forecast an average price of $4,725 next year based on a negative view of Chinese demand. If the latter, you’re probably in the Citi camp. Its latest research, titled “Copper - it’s all about supply” (September 15, 2015), speaks for itself. Citi expects continued supply constraints, a mix of both the unforeseen and the price-related, to “push prices above $5,700 by Q4 2015.”

*Andy Home is a columnist for Reuters. The opinions expressed are his own.