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Wednesday, February 15, 2023

Pair Trade Analysis - Long Platinum & Short Palladium

By Century Financial in 'Investment Insights'

Pair Trade Analysis - Long Platinum & Short...
Pair Trade Analysis -Long Platinum & Short Palladium

*Trading in financial market carries risk and can result in loss of capital.
*This performance is only observed with historical backtests and not traded by the company.

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The product and investment ideas do not consider the risk profile and financial position of the recipient and may not be suitable for everyone. Trading in financial markets and use of margin involves a significant risk of loss, which can exceed deposits. Please read the complete disclaimer carefully.

Disclaimer

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Considering the high volatility of commodity products, sufficient client margin should be maintained in the account.
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The holding rate can change, negatively or positively impacting the trade.
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The testing environment has not considered transactions or any other costs.
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Returns may vary if there is any error in executing the trades.
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Past performance is not indicative of and does not guarantee future results. Please read the complete disclaimer carefully.
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A Pair trade is always taken together and closed together. If one leg is closed and the other is left open, it's no longer a pair strategy and could result in huge losses.
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Any further change in the underlying macros apart from the ones mentioned below may result in significant deviations in the ratio performance and may adversely affect the pair’s performance.

Summary

Platinum was the best-performing precious metal last year, with gains of 11%. This was followed by silver and gold. Palladium was the worst performer, with losses of 6% for 2022. During Q4 especially, Palladium was down by -15%. Platinum, over this same period, was up by 25%. One of the more significant trends visible across both commodities is the growing substitution of Palladium with Platinum. This is visible in the post-COVID trend, with Platinum up by almost 5% and Palladium down by -15% over this period (January’2020 till date).

Platinum & Palladium - Most Coveted Metals in the Auto Industry

Platinum and Palladium are commonly used in catalytic converters to help reduce vehicle emissions, thus making them essential for transitioning to a low-carbon economy. Rhodium is also used as a catalyst; however, it is scarce and much more expensive than the other two.

One of the primary reasons for Palladium being more expensive than Platinum is that it is 15 times scarcer than platinum. One of the other significant reasons for previous high spikes in Palladium prices is due to highly restrictive and administrative policies by Russia in the past. Russia is one of the top 2 world’s largest Palladium producers, the other being South Africa.

Auto catalyst metals have been determined mainly by their availability, durability, price, and stricter emission standards. This has led auto manufacturers to make several switches between Palladium and platinum, depending on which metal was cheaper and more readily available at a specific time. The use of Platinum as a replacement for Palladium has already been accelerating amidst the supply concerns from top Palladium producer Russia. Many automakers substituted Palladium with Platinum even before Russia – Ukraine conflict. As per the latest industry numbers, around 75,000 ounces were substituted during 2021, with 2022 (estimates) around 200,000 ounces. However, the scale of actual Platinum for Palladium substitution has been underestimated, especially given the recent – unexplained – trend for China’s net Platinum imports to consistently exceed the country’s identifiable demand.

Tightening emission legislation from the EU and China will only accelerate this substitution process. This is primarily due to the past diesel gate scandal in Europe and the implementation of China VI standards which is currently heavily influencing Platinum prices front loading. Market estimates believe that around 25% to 35% of the Palladium demand can be substituted at any time. The widening price gap between the two metals will be the main factor affecting the timing and scope of substitution, as it will determine the profitability of carmakers after replacement.

Overall demand and supply forecast

In its latest report, the World Platinum Investment Council has stated that the global Platinum market is projected to be in a deficit of 303 Koz for 2023. The global Platinum demand is expected to rise by 19%, whereas the supply will likely edge by 2%. The Platinum market is forecast to be in deficit after two consecutive years of significant surpluses. This reflects supply that remains well below pre-pandemic 2019 levels and demand growth, despite the unfavourable economic outlook. Wage pressures and power constraints at mines in South Africa, the world’s number one producer of platinum, could further act as a significant tailwind for Platinum prices.

For Palladium, the auto industry is responsible for 70% to 80% of its demand. Once a cheap metal, Palladium rocketed from $900 (2018) to the $3,400 level seen last year. With supply not keeping up to demand for the past years, many EV makers have already gone for or started the substitution process.

Long Platinum and Short Palladium – Current Ratio Analysis

HI: 0.3306

Data Source: Bloomberg
Data & Prices as of : 30/01/2023

The ratio has broken above its multi-year resistance range of 0.53 – 0.55 and is currently trending at 0.62. Below are the different scenarios where the ratio rises or falls:

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Platinum Current Price
$1,012.75
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Palladium Current Price
$1,643.62
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Current Ratio
0.62
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Initial Investment (Both Sides)
$100,000
Hypothetical Scenarios - Long Platinum & Short Palladium Pair Trade
Ratio Platinum
Price
Palladium
Price
Potential
P & L (%)
for Platinum
Potential
P & L (%)
for Palladium
Potential
Gross P & L (%)
for the Pair
Potential
P & L
for Platinum
Potential
P & L
for Palladium
Potential
Gross P & L
for the Pair
0.68 $1,200 $1,765 16% -7% 8% $15,604 ($7,367) $8,237
0.75 $1,400 $1,867 38% -14% 25% $38,237 ($13,570) $24,667
0.56 $896 $1,600 -12% 3% -9% ($11,528) $2,654 ($-8,874)
0.49 $735 $1,500 -27% 9% -19% ($27,425) $8,738 ($-18,687)

Data Source: Bloomberg

Date: 30/01/2023

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The above ratio numbers have been calculated on potential Platinum & Palladium prices. The ratio numbers are for example purpose only.
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The Gross P & L is without the current applicable annual holding cost of 3.60% on the pair position.
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The Gross P & L is without brokerage and other charges.
Risks and Assumptions for Back-tested trading strategies
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The risks and assumptions listed here are not intended to be an exhaustive summary of all the risks and assumptions involved.
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The strategy might suffer from look-ahead bias which occurs due to the use of information or data in a study or simulation that would not have been known or available during the period being analyzed. This can lead to inaccurate results in the study or simulation.
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Future price movements may not be exactly the same as the historical price movements and this could lead to variation in performance.
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Testing can sometimes lead to over-optimization. This is a condition where performance results are tuned so high to the past they are no longer as accurate in the future.
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The model assumes no slippages in trading. Slippage refers to the difference between the expected price of a trade and the price at which the trade is actually executed.
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Drawdowns in actual trading can be higher than the tested system and losses could be significant in the event of leverage.
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Unforeseen events can lead to variation in performance from the tested trading strategy.
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The tested result has been computed with price feeds available from Bloomberg.
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The testing environment has not considered transaction or any other costs.
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Trading indicators used for the purpose of testing has been provided by Bloomberg.
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The strategy might suffer from data mining fallacy, selection bias and backfill bias.

Data Source: Bloomberg
Data: 30/01/2023

Arun Leslie John
Chief Market Analyst

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