Friday, July 3rd, 2020

Trading Coffee Options


The second most highly traded commodity in the world next to crude oil is coffee. Trading coffee options can be profitable but requires a unique skill set. Investopedia writes about the perks of trading coffee options.

“Soft commodities,” which include cotton, cocoa, coffee, and sugar, are appearing in portfolios as an alternate class of trading assets. Though many other agricultural produce like orange juice, sugar, and cotton enjoy the benefit of subsidies at the regional, national, and international levels, facilitating their trade, coffee production and export do not enjoy the same number of subsidizations for international trade. So while it is the world’s favorite drink, coffee is challenging to trade and price.

Coffee futures have been in existence since 1882 on the New York Cocoa Exchange. The present day center for futures and options trading for coffee contracts is the ICE Futures US exchange.

While other popular options (that have stocks or indices as the underlying) allow the option buyer to (theoretically) purchase the underlying stock, coffee options have coffee futures as their underlying. Exercising an in-the-money (ITM) coffee call/put option leads the buyer to a long/short coffee futures contract, which he can then square off at market price or rollover as desired.

Coffee prices are driven by supply and demand. The drought in Brazil drove prices up as Brazil produces forty percent of the Arabica coffee in the world. Trading coffee options often has to do with being a Central and South American weather forecaster.

Drought in Brazil

Brazil has been experiencing a devastating drought. It has not been this dry in the largest country in South American for nearly 100 years. National Geographic provides insight.

In São Paulo, Brazil, which is suffering its worst drought in almost a century, Maria de Fátima dos Santos has lived for days at a time with no water, relying on what she had carefully hoarded in bottles.

But in the Bolivian Amazon, about 1,800 miles (2,897 kilometers) away, Nicolás Cartagena recalls the day almost a year ago when floodwaters rose to the thatched rooftops of Indian communities, destroying crops and washing away homes.

The drought in South America’s biggest city and the flooding in the Amazon are being triggered by the same wind-driven weather phenomenon that scientists say is probably a harbinger for more extreme water shortages and flooding across the continent.

No one fully understands this boom-and-bust cycle, but meteorologist José Marengo says it has been triggered by a sprawling high-pressure system that settled stubbornly over southeastern Brazil. That region is usually at the end of a long loop of moisture-bearing trade winds. Last year, however, this system went awry.

The same weather that has endangered livelihoods and lives in Sao Paulo reduced the coffee crop in Brazil last year by about ten million bags (154 pounds each) driving up prices. When trading coffee options on coffee futures one can look ahead a few months or a year. As the weather cycles back around and the coffee crop returns to normal those who purchase calls in trading coffee options may prosper.

Options on Futures Contracts

The Options Guide explains how futures options work.

A futures option, or option on futures, is an option contract in which the underlying is a single futures contract. The buyer of a futures option contract has the right (but not the obligation) to assume a particular futures position at a specified price (the strike price) any time before the option expires. The futures option seller must assume the opposite futures position when the buyer exercises this right.

Trading coffee options is really trading options on coffee futures. Now that prices are high due to the drought in Brazil one might expect to see lower prices in the future when the rains return. Those who expect this to happen will probably buy puts on coffee futures to benefit from a fall in prices and those who expect things to get worse will probably buy calls.

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