The current level for commercial interest is one of the most bullish net commercial positions in history only seen two times since 1986: Nov. 28, 2003 and Dec. 12, 2008. Both set off massive bull market moves.
Commercials have loaded up on coffee and the latest surge has taken them to historic bullish high ground. This has only been seen two other times before in 2003 and 2008. Both times preceded fantastic multi-year bull market moves. If history is a guide, all-time highs could be achieved over the next few years.
Despite all the bearish factors that have been the basis for the bear market in coffee prices over the last year that included Europe falling into the abyss (reduced coffee demand), large demand switch from Arabica to Robusta, a crashing Brazilian real, slowing coffee demand in Brazil, record Robusta production in Vietnam and record Brazilian crop, the commercial interests are long and see great long term value. As always, in order to make money in a commodity you have to see the bullish fundamental picture coming before everyone else does and before such bullish underpinnings begin to get priced in the market with higher prices.
It is very hard to buy when everything seems bearish but that is the nature of the beast. If it was easy everyone would be trading commodities. All my homework indicates that a new bull market is about to begin. The same contrarian streak that allowed me to buy the last bull market in coffee despite widespread bearishness in 2010 is at work here and now.
The prudent play is to go long December 2012 coffee and place an option collar around it to reduce downside risk. With uncertainty around U.S. elections, global central bank money printing or lack thereof, possible Chinese fiscal stimulus or lack thereof, possible war with Iran, possible Europe implosion, banking system crisis and possible worsening global recession, the macro picture offers huge risks to any long position.
Of course these risk factors have been in place for many years and will remain in place for years to come. With a contract as large as coffee and with the higher volatility typically seen in coffee one should remain focused on risk control. An option collar is a perfect vehicle to do this. Here is the trade: Buy 1 Dec. ‘12 coffee futures at $1.6310 closing Friday price, buy 1 Dec. ‘12 150 put at 3.03 closing price, sell 1 Dec. ‘12 180 coffee call at 3.10 closing price. What this does is essentially give you a $1.50 floor under your straight long position at no cost as the buy and sell for the options are essentially the same premium.
Should the coffee market collapse because of a macro event then the puts will appreciate dramatically minimizing your loss to at most the difference between the executed futures price and the put strike. One would then have the flexibility to take the put option off at a large profit and ride the coffee futures market back up. If the coffee market takes off as the bullish fundamentals take hold in a money printing environment, then profit can be made up to the short call strike. Once prices move over $1.80 the profit potential is capped. Of course the flexibility exists that if one felt the bull market in coffee was getting underway you could take the short call off and let the futures run higher to capture further gains.
What is great here is that a substantial profit would already be in place that would dramatically reduce the risk of being naked long as one can apply a trailing stop strategy to manage risk. One could also apply a different collar at a higher strike price level to bracket it once again. The whole point of using an option collar strategy is that it allows for a calculated loss that is quantified and allows for flexibility.