Nov. 15, 2006 — Investors reading an article on a stock or commodity typically expect one question answered at the end of the piece: Is it going up? Or is it going down?
Options sellers, however, learn that the market is not that simple. An outlook such as “I am not sure if it is going up or down in the short term, however, there is a very high probability it will not go to this level” may seem pointless to some investors. But this type of scenario is exactly the kind of opportunity that gets option writers rubbing their hands together. Option sellers don’t care where prices are going. They only care where prices are not going.
This brings us to the coffee market. The NYBOT coffee contract has experienced a healthy price rally over the last three weeks. From Oct. 23 through the close on Nov. 9, coffee prices increased by 18.3¢ per pound (18%) to close at more than $1.19 per pound. The market rallied primarily on a handful of fundamental issues occurring at the same time:
The coffee flowering period took place in Brazil during October and the consensus is that it did not go as well as expected. The flowering period is a critical time of year for coffee plants. Healthy flowers form on the coffee bush, which then drop off, leaving a red “cherry” that eventually turns into a green coffee bean. The more and healthier the flowers, the higher the quantity and quality of bean the bush will produce the following year. This year’s flowering period saw less than ideal weather conditions, meaning not as many flowers as was generally expected. In combination with an already expected “off” year in coffee production next year, next year’s Brazilian crop could produce 25% less coffee than this year.
The Brazilian farmer strategy of “holding out” has worked well this year. As prices start to rise, farmers will simultaneously hold supply off the market in an effort to see how much they can get for their crop. This coordinated effort has helped drive prices higher immediately following harvest this year.
The Vietnamese coffee crop, widely expected to dampen prices as it comes on the market, has been slow in coming.
The Brazilian agricultural ministry is helping to stoke the bullish flame by announcing that this week’s estimate of 2.1 million bags of coffee in government storage is the lowest ever.
Fundamentals such as these have given some traders the impression that coffee is in short supply and that supply is getting shorter. This has brought both small spec and fund buying into the coffee pit.
However, markets can often get sidetracked as traders focus on the popular story of the week and overlook the bigger picture. It is true that the Brazilian flowering period this year could have gone better. While the first official Brazilian Ag estimate is not due out until next week, private estimates are pegging next year’s (07-08) crop to be somewhere near 32 million to 33 million bags, about where the 2005-2006 harvest came in. The caveat however, is that this crop will not even begin harvest until May of 2007. At this time, Brazil has just finished the 2006 harvest. And it has been massive. While the official government estimate expected Brazil to produce 41.6 million bags of coffee, it is now nearly certain that harvest yielded near 45 million bags. And while the Ag ministry talks up the low level of government stocks, Brazilian farmers sit on the third largest coffee harvest in recorded history.
They can’t sit on it forever, however. Brazil is known for holding product until prices climb and then selling in bulk. Selling in the cash market has picked up substantially on the rally and Brazilian beans are now moving into export channels at a brisk pace. In addition, the long awaited Vietnamese harvest will finally move into full swing over the next two weeks. Vietnam is expected to harvest 14.5 million bags of coffee in 2006-2007, 26% more than in 2005-2006. New coffee hitting the market will give Brazil some competition, which will almost certainly encourage growers to begin unloading stocks onto the open market ahead of their Vietnamese counterparts.
While we’re not bold enough to proclaim today’s sweeping reversal the top in coffee prices, we cannot see coffee moving substantially higher from current levels given the existing situation. While a smaller Brazilian crop in 2007 could very well have an impact on market prices later next year, the December 2006 to May 2007 Coffee contracts will still be based on 2006 coffee, which, as we have demonstrated, are more than ample.
While we do expect coffee prices eventually to recede, we cannot make a statement such as “coffee prices are set to move immediately lower.” We can say that, in our opinion, it is highly unlikely that coffee can rally another 20% to 30% given the heavy supplies about to hit the market. While day traders or short-term players may not find this a precise enough projection, as option sellers, it is as close as you have to be.
The current rally has resulted in inflated premiums for coffee-call options for early 2007 contracts at strikes higher than the levels mentioned above. These are high probability plays over the next few weeks and we will be working closely with clients in strike and premium selection in the coming days.
Investors interested in option writing can catch Liberty Trading’s James Cordier LIVE at the fourth Annual Las Vegas Traders Expo – Nov. 17 through 19. James will be giving two seminars over the weekend. Register to attend at http://www.tradersexpo.com/tradersexpo/lasVegas/
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James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. His market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Cordier and Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers. Liberty Trading Group
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
