(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON, April 30 Nickel is the only game in town right now among the base metals traded on the London Metal Exchange (LME).
LME three-month metal has edged back from the 15-month high of $18,715 per tonne reached on Monday but it is still up by over 30 percent since the start of the year. The next best performer among the LME pack is tin, trailing far behind with year-to-date gains of just 5 percent.
Nickel is trading a strong fundamental story with Indonesia's ban on exports of nickel ore expected to turn the market from supply feast to supply famine in double-quick time.
Extra spice comes in the form of possible sanctions against Russian producer Norilsk Nickel as geopolitical tensions around Ukraine ratchet up.
The company, which last year produced 285,000 tonnes of nickel, has not yet been targeted but the most recent sanctions include Sergei Chemezov, who sits on its board, suggesting the potential sanctions net is drawing closer.
Investment money has flooded into nickel in pursuit of this bullish narrative, both volumes and open interest mushrooming to record levels.
That the LME market is overheating is not in doubt. The scale of the price rise this year has wrong-footed even the most bullish commentators.
But such is the power of the narrative that any pull-back is likely only to attract fresh buyers eager to scramble aboard the bull train.
Just how high might nickel go, though? $20,000? $30,000? $40,000?
Some evidently believe so, judging by the nickel options landscape.
There are 6,902 lots (around 41,400 tonnes) of open interest on call options at the $20,000 strike spread over the June-December 2014 period.
Call options give the buyer the right to buy metal at a specific price on a specific date.
At the far extreme of the bull spectrum in December itself are 200 lots of call open interest on the $30,000 strike. And if that seems a bit far-fetched, what about the 200 lots of call open interest at the $40,000 strike in December 2015?
The options segment is where the full gamut of bullish expectation in this market is laid bare.
And options volumes have boomed in tandem with the underlying price rally.
Almost 222,000 lots of nickel options traded on the LME in the first quarter of this year, already more than in the whole of 2012 and rapidly approaching last year's tally of 285,000.
Traded options activity in March itself was 81,083 lots, the highest monthly turnover in at least five years and quite possibly an all-time record.
Thousand-lot clips have been moving through the LME nickel options market, startling dealers who have in the past often struggled to match up orders a fraction of that size.
That in itself says much about the nature of this rally, nickel luring in mainstream investors to a sector they have been shunning for many months.
Moreover, banks such as BNP Paribas are still promoting options as the best way to position for further upside potential.
BNP analyst Stephen Briggs, for example, advises "buying out-of-the-money call options, especially on short-term dips". ("Nickel on Indonesian steroids", April 24, 2014).
"Specifically, we recommend a strike of $22,000/t for Q4'14. The cost could be partly offset by selling calls at a strike of, say, $29,000/t; such a price level is possible in the longer term but not, we feel, within the next six months."
BULLISH HEAT MAP
And investors, it seems, are heeding that sort of advice.
Exchange open interest over the next eight months through December is markedly skewed to call options (54,807 lots) over put options (31,406 lots).
The greatest concentration of market open interest this year is in December itself.
The distribution of that month's open interest <0#MNIZ4+> serves as a bullish heat map.
******************************************************* Graphic on Dec 2014 nickel call options open interest: link.reuters.com/qaw88v *******************************************************
The $20,000 call strike is the stand-out with 4,525 lots of open interest, but there are also significant clusters of positioning on the $21,000, the $23,000 and the $24,000 strikes. All the way up to that super-bullish 200-lot bet on the $30,000 strike.
Moreover, what is visible on the LME itself may be only the tip of a larger iceberg.
Despite the recent liquidity boost, the LME traded nickel options market is still a highly constrained space and it's quite possible that bigger players have been entering the market via over-the-counter (OTC) options.
Dealers may well hedge their OTC exposure in the traded options market but even if they do, the size of any hedge is likely much smaller than the underlying position.
MORE VOLATILITY PLEASE?
All of which promises much more volatility ahead.
Options exposure has to be hedged by the seller in the futures market and the rapid accumulation of open interest in the $19,000-24,000 band suggests such "delta-hedging" could become a major price driver in its own right if the underlying price does make it into that price zone.
Remember that "delta-hedging" is a double-edged sword. In a rising market, option sellers have to hedge-buy futures, but if prices turn, those hedges have to be sold out again.
Now, imagine that the nickel price is trading around the $20,000 level at the approach of the December prompt date, forcing the options market to adjust futures positions against the 27,150 tonnes of open interest on that strike.
The suspicion that there is another layer of invisible open interest in the OTC market only raises the potential stakes.
Nickel's ascent so far has been almost vertical. Some sort of correction is now widely expected.
But with banks pushing investors to use any pull-back to accumulate further upside exposure in the form of call options, positioning is only likely to increase over the short term.
Options will act as a price magnet, serving as a self-reinforcing bull driver on any major rally, but will also accelerate short-term choppiness, particularly around major concentrations of open interest.
So, if you want to join the Great Nickel Rally, just remember to buckle up. It's shaping up to an extremely bumpy ride. (Editing by William Hardy)