Trading Coffee Options Part II

Identifying a "strike" price for your option is a fairly simple process of asking your broker for all of the price variations relative to expiry dates. The strike price can be thought of as a derivative of the volatility and probability relating to the "C".
The costs attached to purchasing options are affected by the amount of liquidity in the market (for coffee the liquidity is low and therefore expensive), the time period related to the contract, and the price volatility (volatility increases the price of the option).

Liquidity or lack of liquidity means the amount of active open interest in a series of option contracts. In practical terms, if you are offering something for sale and there aren't many buyers, the "spread" between the asking price and the bid price increases. This is important in situations where you may want to sell a position quickly and be forced to take a lower price than you paid because of a lack of buyers. This type of loss is referred to as "slippage", or the loss taken on the gap between bid and ask on a quick transaction. Conversely, as the price moves either up or down such that it approaches in the money, the spread between bid and ask narrows as interest spikes. Purchasing options on the "C" may be less attractive due to the fact that there is relatively low open interest in coffee options contracts and the price premium for many is unattractive.

Determining the value or cost of time attached to an option is as simple as identifying options with the same strike price, but different expiration dates and recording the value of the extra time. The more time left on the option, the more time for move to occur to put it in the money, the more expensive the option price is.

Volatility or conversely price stability affect the prices of options as well. Price movements which routinely alter the price of the contract in and out of the money, sometimes several times during the period of the contract, will be much more expensive than options on commodities or shares with stable pricing. Lately coffee has experienced some pretty wild fluctuations in relatively short periods of time and therefore the time premium can be expensive in these situations. Currently, the price premium on a coffee contract costs a premium of $0.10 over/under the "c" with a November expiry. For a $37,500 lb contract, the option will cost approximatley $3,750 before you get in the money. This contract works if we are confident that the price for coffee will either increase or decrease more than 10 cents per pound over the next 8 weeks or so.

Remember, as the contract approaches the expiration date, the value of the contract decreases if it is not in the money with each day. The key when trading options on goods with low open interest, high volatility is to stay on top of the pricing and get out of your position the moment you feel it is in the money with transaction costs plus your target premium. Also, with options, someone either wins or loses on every contract. With each option, there is always a counterparty who is betting the exact opposite of what you believe is going to happen will happen. Don't underestimate the intelligence of your counterparty!
I'll take a week and knock off another post on options trading, next time dealing with the process to place an actual order for purchase or sale.