Protective Carry Trades
We often talk about spread risk and the importance of proactive position management. Commodity traders are naturally short futures due to their physical length, so one of the biggest threats to profit is a backwardation in the forward curve.
But you don’t need to wait until you’ve physically bought the material to start managing this risk. By executing borrows in advance, known as protective carries or pre-borrows, you can lock in protection against adverse spreads and, in some cases, profit from contangos.
Let’s say it’s October 2024 and a trader signs a contract to purchase 1,000MT of aluminum per month for delivery from January through December 2025. The matching sale contract is already lined up but it prices one month later, from February 2025 through January 2026. Both contracts price on the Monday prior to the 3rd Wednesday of M.
This setup means that every month, the trader will be short futures for the month of their purchase but won’t close that position until the next month’s sale prices. Without taking any action, they’re exposed to spread risk for the entire 12-month period.
The Cost of Doing Nothing
Let’s take January 2025 as an example. If, when they go to price that month’s purchase, the Jan–Feb spread is in a $20/mt backwardation, they’ll be forced to borrow that position at a cost, buying Jan futures and selling Feb. In this case, they lose $20/mt.
As we say at Perfectly Hedged: “Borrowing in a Back is Bad.”
Trader incurs cost of Jan-Feb backwardation
The Alternative: Protective Carry in Advance
Now imagine back in October 2024 when the trader signed the deal, the Jan–Feb spread was in a $10/mt contango. By executing a borrow trade then (buy Jan, sell Feb), the trader could:
Lock in the contango and earn $10/mt.
Neutralize future spread risk. When January arrives, the purchase pricing offsets the long Jan future. No further borrowing is needed.
Jan-Feb borrow executed in October 2024
Full-Term Protection: Jan to Jan
Taking it a step further, the trader could execute a full strip trade in October, borrowing from Jan 2025 through Jan 2026. This would:
Lock in the entire 12-month contango.
Remove spread risk entirely across the life of the contract.
Leave the trader neutral every month as the physical purchase and sale pricing offset one another.
By Jan 2026, the final short futures leg from the original borrow would be offset by the pricing of the final physical sale.
Jan '25 - Jan '26 protective borrow executed October '24
Optionality: The Value of Flexibility
Companies with consistent annual carry needs often pre-borrow Jan–Jan or Dec–Dec. But if market conditions shift, a pre-borrowed structure also allows for optional upside.
Let’s say a $50/mt backwardation emerges between Jan and Feb 2025. If the trader can convince their buyer to move the sale up from Feb to Jan, they can lend into that backwardation and capture the full $50/mt.
That kind of flexibility is only available to companies with a proactive spread strategy already in place.
Jan ‘25-Jan’26 protective borrow followed by Jan’25 - Feb ‘25 Lend
Takeaway
Protective carry is about more than managing risk, it’s about creating value. Companies that understand their carry needs and take advantage of early opportunities in the spread curve can turn backwardations from a threat into a source of profit.
Is your team thinking ahead on spreads or waiting to be caught off guard?
