What it means
The exchange dates back to the 1870s, when merchants in London needed a reliable way to agree prices for metal that was shipped across the world. It now offers futures and options contracts, and a network of approved warehouses in many countries that can deliver physical metal.
Most contracts are settled in cash or rolled forward, but the possibility of physical delivery keeps futures prices tied to real metal. A distinctive feature is that LME contracts have daily prompt dates (the dates on which a contract settles) for the first three months, then weekly and monthly dates further out.
This allows buyers and sellers to match a contract to the exact day they need metal. Each contract has a standard lot size, for example 25 tonnes for copper, so that prices and quantities are clear.
Trading takes place on electronic systems, by phone between members and in the Ring, a traditional open-outcry trading floor where members shout prices in short sessions. The official prices set each day are widely used in contracts between miners, smelters and manufacturers.
A contract might say that a supplier will charge the LME price on a given day plus a fixed premium. Hedging is the main business use.
A cable maker worried about rising copper prices can buy futures to lock in a cost, and a mining company worried about falling prices can sell futures to fix its revenue. Speculators and investors also trade, which adds liquidity but can increase price swings.
Using the exchange involves margin, which is cash posted as security for each position. If prices move against a position, the member must add more margin quickly.
Smaller businesses usually access the market through brokers, and they should understand both the hedge and the cash needed to support it.
In practice
Real-world examples.
Example
A cable manufacturer agrees to supply wiring to a construction firm at a fixed price for the next twelve months. To avoid being hurt by rising copper costs, it buys LME futures covering its expected needs. The hedge allows it to quote a fixed price with confidence.
Example
A zinc mining company expects to produce 5,000 tonnes next quarter. It sells futures contracts to lock in a price that covers its costs and leaves a margin. If the price later falls, the gain on the futures offsets lower sales revenue.
Example
A commodity trading firm holds physical aluminium in an approved warehouse. It sells a futures contract for later delivery at a higher price than today's market. The difference, after storage and financing costs, is its return.
Formula
Calculation
Contract value = Price per tonne x Tonnes per lot
Gain or loss = (Price change per tonne) x Tonnes per lot x Number of lots
Assume copper trades at $9,000 per tonne and a lot is 25 tonnes. One lot is worth $9,000 x 25 = $225,000. A manufacturer that needs 100 tonnes buys 100 / 25 = 4 lots as a hedge. If the price rises by $500 per tonne, the futures gain is $500 x 25 x 4 = $50,000, which offsets the extra $500 x 100 = $50,000 paid for physical copper.Case study
Seen in the real world.
Brackenridge Cables is an illustrative, fictional manufacturer that signed a two-year contract to supply electrical cable at fixed prices. The finance director realised that a sharp rise in copper prices could wipe out the margin on the deal.
She worked with a broker to buy copper futures on the London Metal Exchange for about 70% of the expected volume, using contracts that matched the delivery schedule. She also set aside cash to cover margin calls, which are demands for extra security when prices move against a position.
Copper prices rose by 15% in the first year. The hedge gains covered most of the increase in the cost of metal, and the contract remained profitable. The story is illustrative, but it shows the value of planning for both the hedge and the cash it may need.
Watch out
Common mistakes.
- Hedging more than the business actually needs, which turns a hedge into a speculative position.
- Forgetting margin, so that a hedge that is correct on paper causes a cash shortage.
- Assuming the futures price will equal the spot price, when differences arise from storage, interest and delivery timing.
Questions
People also ask.
Which metals trade on the LME?
The main contracts cover base metals such as copper, aluminium, zinc, nickel, lead and tin, and the exchange also lists other metals and related contracts.
Do I have to take delivery of the metal?
Not usually, as most positions are closed or rolled before expiry, but physical delivery is possible and keeps prices linked to the real market.
Why does the LME price matter to companies that never trade on it?
Many supply contracts are priced as the LME price plus a premium, so the exchange sets the base cost.
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