Freeze-driven Coffee Bull? Try decaf & write calls
If you’re a mainstream investor used to gauging price/earnings ratios or milling through bond yields, selling options on coffee futures may sound like launching a trip to the moon. Soft commodities are also sometimes referred to as exotics—most likely named by mainstream investors more comfortable with familiar assets such as gold.
If you’re considering branching out into the diversified commodities markets, especially as an option trader, you don’t want to avoid these markets. For it is in these backwater food and fiber sectors—away from the glow of public spotlight—where fundamentally based opportunities and large dislocations often exist. With the 2017 Brazilian harvest wrapping up and a potentially record crop next year, a supply burden should keep prices in check into next year.
Here, we present just such a potential opportunity in the coffee market.
The Seasonal Coffee Cycle
Brazil is by far the world’s largest producer and exporter of coffee—in particular, the higher quality Arabica coffee used to satisfy the majority of the ICE Futures U.S. Coffee futures contract. Thus, developments in the Brazilian crop are key to forecasting coffee prices (see “Coffee producers,” left).
In Brazil and the southern hemisphere, coffee trees experience a bi-annual “on/off” cycle. This means the trees tend to produce more beans during “on” years and fewer beans during “off” years. Thus, every other year should theoretically produce a higher yielding crop. As a trader, you should know if the year you are in is an “on” or “off” year.
In addition, the coffee growth cycle has three key seasons you should be aware of: Flowering, growing season and harvest.
The coffee bean life cycle begins in October with flowering season. This is the most critical time for the upcoming crop. As the flowers drop off, they leave in place a cherry. This cherry is what ultimately turns into what we know as the coffee bean. The number of flowers will determine how big the upcoming crop will be; and the weather will help determine how many flowers form on the trees. As October is typically the beginning of the rain season, it often coincides perfectly with flower formation.
However, if rains are late in coming, worry, and, thus, prices can increase. It is not uncommon to see a weather premium building into prices during flowering season. However, these can often be trading opportunities, especially for call selling, as prices can decline sharply when the rainy season begins and flowering is complete.
This Brazilian growing season lasts from November through March. During this period, weather can sometimes be a factor. But in Brazil, it’s typically warm and wet. This time is typically reserved for analyzing the true size of the upcoming crop and keeping an eye on its health.
In March, the Brazilian coffee harvest typically begins and can last all the way through the next flowering season. Harvest season also overlaps the Brazilian winter, which is June-September. This can also be a time for weather concerns as a harsh freeze can hinder or damage the harvest and/or hurt tree development for the upcoming flowering.
Knowing the seasons and the seasonal price tendencies for coffee can help you better identify the best option selling opportunities.