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.