What is a Physical Premium?

When I teach hedging I explain that when traders price a physical purchase, they sell futures against it; and when they price a physical sale they buy futures. This often prompts the same questions:

"If the flat price is hedged, how do traders make money?"

While there are many ways to generate a profit in commodity trading, one of the simplest methods is through physical premiums.

The price of a physical commodity is rarely just the exchange price. it is typically the exchange price plus or minus a physical premium.

That premium reflects the specific form, quality, brand, location, delivery period, and contractual terms of the commodity. It is also influenced by costs such as freight, financing, storage, and credit.

Although we call it a premium, physical material can also trade at a discount to the exchange price.

But premiums are not simply a matter of cost, they are also an important indication of physical supply and demand. However, where exchange prices often reflect the global balance for a commodity, physical premiums are far more regional and product-specific.

The same commodity can command a very high premium in one geography and a much lower premium, or even discount, in another without any meaningful move in the flat price.

These differences can be created by seasonal demand, logistical bottlenecks, geopolitical events, production disruptions, or even severe weather.

All else being equal, a rising premium indicates that a physical market is tightening. Buyers are competing for limited material, allowing producers and traders to command higher premiums for delivery.

Conversely, a falling premium often indicates that supply is larger than demand and consumers do not need to pay high premiums to attract material.

Traders that hedge their outright price exposure can still generate profits by buying at a lower premium than they sell at, after accounting for freight, finance, storage, and credit costs.

Buying low and selling high sounds simple, but it is far from risk free. Traders will often need to take a view on forward premiums.

If they expect premiums to rise they may purchase and hold inventory, financing and storing it until it can be sold at a higher premium.

If they expect premiums to fall, they may sell material for future delivery before purchasing it, effectively taking a physical short position they hope to cover later at a lower premium.

Traders can also lock in purchases and sales back-to-back, creating a margin through their logistical capabilities, financing advantages, regional relationships, or global positioning.

Understanding physical premiums is critical to understanding regional supply and demand, and how commodities traders make money even when the exchange price has been hedged.