As the concept of selling options continues to grow more popular with retail investors, volatility has become the new buzzword for traders in search of high premiums. Indeed, selling (or writing) options has its benefits. There’s no need to pick absolute market direction, no need for perfect timing, no agonizing decisions on where to take profits.
But option writers cannot live on volatility alone. A firm understanding of the fundamentals affecting the underlying market is necessary to provide an investor with the edge he needs to sell the options with the highest probability of expiring worthless.
So, traders should seek volatility first, then select the markets that exhibit the clearest long-term fundamentals — bullish or bearish. A prime example of this kind of commodity in 2006 is the coffee market.
BIG PICTURE TRADE
Coffee started out strong in 2006, topping out at just above $1.25 per pound in late January. A sharp reduction in the 2006 Vietnamese crop coupled with a wave of fund buying in many commodities drove coffee to its highest levels in six months. The strength was short-lived, however, and coffee proceeded to retrace its gains throughout the next two months.
Coffee bulls continue to beat the drums of dwindling supply and growing domestic demand in coffee’s key producing country, Brazil. But they are looking at a tiny part of the bigger picture. Longer-term coffee fundamentals make it a market that, barring a crop-killing freeze, will struggle to match the levels seen earlier this year and should gravitate to price levels below $1 per pound by the third quarter of 2006.
Coffee is one market that is very favorable to fundamental trading. There are a few producers that make up the majority of production. Crop figures and demand estimates are available six to 12 months out and can be projected somewhat accurately. If a retail trader can focus on these big picture fundamentals and tune out the short-term noise, it’s relatively easy to make a fair estimate of current prices based on past supply and demand situations and accompanying prices.
This simple approach may not tell us where the market is going to go, but it can give a fairly clear idea of where the market most likely will not go. As an option writer, that’s all you need to know.
SUPPLY
Coffee futures at the New York Board of Trade (Nybot) were trading near 95¢ per pound in late December 2005 when Vietnam announced excess rains in that country would likely reduce the 2006 coffee crop by 30% or more. That brought on a wave of speculator buying, especially from the ever-growing commodity and hedge funds, eager for a new market to park investor capital.
But every bull move runs it course, and by late January the Vietnamese crop damage was priced in, and traders started looking toward the upcoming Brazilian coffee harvest that begins in May. Prices corrected accordingly.
To put this in perspective, Brazil is the world’s largest producer and exporter of coffee and grows more than three times as much coffee as Vietnam. Brazil carries even more weight when we consider that Vietnam produces primarily the Robusta variety of coffee traded in London whereas most of Brazil’s production is Arabica coffee, which is what’s traded at Nybot.
Brazil experiences an alternating on/off cycle in coffee production; higher production years are usually followed by lower production years. This is a natural cycle of coffee plants. Last year was an off year for coffee production. The U.S. Department of Agriculture estimates that Brazil produced nearly 36 million bags of coffee last year. This resulted in a 3.4-million-bag world production deficit for 2005 and provided fodder for coffee bulls throughout the year.
That also means that 2006 will be an on year for Brazilian coffee growers. While earlier estimates had the crop rivaling 2002’s monster 53-million-bag harvest, a dryer than normal end to the flowering season in October has since reduced the estimate to about 44 million bags, of which roughly 75% will be Arabica. This is not a record, but by no means is it a small crop. In fact, if the estimate holds true, 2006 will be the third largest Brazilian crop on record.
DEMAND
Unlike economy-driven commodities such as copper and aluminum, demand for coffee does not shift dramatically from year to year. However, the longer-term trend shows a higher percentage of the overall population is drinking coffee and drinking more of it. In addition, coffee is just starting to gain a foothold as a favored beverage in Asia, which could mean massive increases in coffee demand in the years ahead.
The current leader in coffee consumption is the United States, and demand here is rising. A recent survey by the National Coffee Association shows that 56% of Americans considered themselves daily coffee drinkers in 2006; up from 53% in 2005 and 49% in 2004. Also, 82% of the overall population drinks coffee. The increase is attributed primarily to the advent of gourmet coffee as a hip beverage.
In the shorter term, the International Coffee Organization estimates a 2006 world coffee production figure of 121 million bags and a world consumption figure of 119 million bags, resulting in a 2 million bag production surplus for 2006.
THE E.U. FACTOR
Regionally, the U.S. Northeast has the highest consumption of coffee with nearly 61% of the population as daily drinkers. This explains the seasonal tendency for U.S. coffee demand to wane during the summer months and then steadily increase during the winter months. This seasonal demand tendency also holds true in nations in northern Europe and is one reason why coffee prices tend to weaken during the June to August period.
This tendency could be enhanced this year. On Jan. 2, 2006, the European Union began charging a 9% tariff on Brazilian instant coffee imports. As a result, Brazilian exports of instant coffee to the European Union are down 35% through the first two months of 2006.
Exports in January and February totaled 379,816, 60-kilogram-bags as compared with 513, 456 bags throughout the same period last year, according to Brazilian Commerce Ministry data. Germany, Finland and the U.K. are the primary markets for Brazilian instant coffee.
Because Brazilian instant coffee is 9% more expensive than its competitors, it is likely E.U. consumers will switch to other suppliers, many of which provide the Robusta variety. As Brazil primarily produces Arabica coffee, traders of the Nybot contract should take note of the potential for additional supply on the market. Those who trade London coffee, however, could anticipate a slight bump in demand for their Robusta variety bean.
The industry wants to open a dispute-settlement panel in the World Trade Organization against the European Union’s tariff. However, these things tend to take many months, if not years, to resolve. The tariffs will most likely be in place this summer, meaning more of a drop off in summer consumption of Arabica coffee from northern Europe than usual.
WHAT ABOUT THAT FREEZE?
With this crop size and a projected supply surplus, coffee would seem to be an ideal market for selling calls on the August and September contract, when harvest usually wraps up in Brazil. But one possible obstacle traders should be aware of before they start putting call premium away in their accounts is the Brazilian freeze season (see “All buzzed up,” below).
Throughout the years, coffee prices have gained a reputation for making big moves during the winter in the Southern Hemisphere, based on a few exceptional years when a rare, but crop-damaging freeze descended on the new developing crop. Even in non-freeze year’s, coffee prices are very sensitive to cold weather forecasts from May through August. But should a trader hurry to jump on the freeze bandwagon, or is this an opportunity to get short a market with bearish longer-term fundamentals (see: “Seasonal scare,” below)?
While the freeze season may get a lot of hype, the chances of a freeze causing significant damage to the Brazilian coffee crop have significantly dropped in the last 10 years. After crop-damaging freezes in the 1980s and early 1990s, Brazilian producers began planting replacement trees further north toward the equator, moving production to a more moderate winter climate and out of frost prone zones. While the chances of a crop-damaging freeze can never be completely eliminated, this is such a significant fundamental change that the heavy speculative buying often seen in early to mid summer could become a non factor within the next four to five years.
Even before this change in growing areas, a sustained summer price rally in coffee has been rare. Normal seasonal averages generally see coffee experience a rally in May or June as bullish speculators buy the market. This will often be followed by a sustained fall in prices as new Brazilian supply gets dumped on the market just when the Northern Hemisphere heads into the lower consumption summer months.
Thus, it is possible that coffee prices could be showing some strength by mid June as speculators buy the market in hopes of a freeze. This isn’t necessarily a reason not to sell calls. Quite the contrary, barring a bona-fide crop-damaging freeze in Brazil, price strength during the May to June period would be an exceptional opportunity for selling call premium in coffee. A freeze scare provides an annual built-in bump in volatility, beneficial to options writers selling volatility.
TRADING STRATEGIES
If speculator buying does occur through May or June, it is not uncommon to see volatility in coffee options increase substantially. In the past, we’ve witnessed exceptional premiums available in strike prices more than double what the price of coffee was at the time.
For the aggressive trader willing to hold his position, selling naked calls far above the market can be a high-percentage strategy for putting a large chunk of premium into an account quickly. At this time of year, we favor the September contract as deterioration tends to occur rapidly if there is no threatening weather by July. Selling naked calls, however, does entail a risk that could make some traders uncomfortable. In the unlikely event that a real freeze would occur, a naked position could result in a considerable loss.
This is why vertical call spreads are more attractive in the coffee market. A vertical spread is a covered position that offers limited risk and lower margins. Assume a trader wants to sell a September coffee 1.80 call on a rally in May. Instead of selling it naked, a trader could take part of the premium collected from the 1.80 call and purchase a 1.90 call for protection. The total risk on the trade is then limited to 10¢. More important, even if coffee rallies substantially but does not exceed the 1.80 level, the 1.90 call will increase in value almost as fast as the 1.80 call, meaning temporary losses will be mostly covered, allowing the trader to remain in the trade much longer.
The profit zone remains the same as selling the 1.80 put naked. If the market is anywhere below 1.80 at expiration, both options will expire worthless and the difference in premium between the two strikes are the profits. Vertical spreads are outstanding strategies for trading volatile markets and can often offer a higher return on margin than selling naked.
James Cordier and Michael Gross are portfolio managers with Liberty Trading Group in Tampa, Fla. They are the authors of the book The Complete Guide to Option Selling (McGraw-Hill, 2005). They can be reached at www.libertytradinggroup.com.
