The Exchange Traded Commodity Price for Arabica (The "C")has been a consistent topic within this blog. It is of such vital importance to both farmers and consumers that I've dedicated a great deal of thought and effort to articulate the factors that affect the price settlement every day. Last year in the middle of a flurry of attention following the price eclipsing $3.00, I posted some thoughts on delinking the Specialty Price from the commodity price although with somewhat sketchy details about basing it on a composite retail price.
In the past few weeks I've begun to flesh out some ideas with the goal of providing some security (hedge) and stability (certainty) within the Specialty Coffee market. This proposal is not universally suited for all and admittedly excludes parties driven solely by profit. First, I'm restricting this concept to those companies who purchase direct from farm, where interaction and negotiation with decision makers at source is possible. Second,this mechanism is intended for growers and purchasers who are both dedicated to price stability with sufficient risk/reward to satisfy normal profit motives. Last, the integrity of the proposed contracts must be unassailable as each participant is the counterparty insuring the hedge.
The proposal is the creation of a proprietary Tailored Options Contract (think of it as an insurance policy) which would be negotiated by each party under the auspices of a Third Party Registrar. This contract would be very different from normal exchange traded options contracts where the counterparties never know who is on the other side of the trade.
The basic structure can be best explained by the following: The Roaster sells a Put at the agreed strike price with an approximate 10% premium which is purchased by the Grower. The Grower Sells a Call at an agreed strike price with an approximate 10% premium which is purchased by the Roaster. Both share an expiration date at harvest the following crop year, for example Jan 1,2013
Example: Let's assume the agreed price for this years crop is $3.50 per pound farm gate. Our Roaster sells a January 2013 Put Option to the grower at $3.15 Strike Price and and receives $0.35 in proceeds. This gives the Grower the Option, but not the obligation to sell his/her coffee next year for $3.15. The Roaster who sold the Put in turn has the obligation to purchase if the Grower exercises his right. So why would the grower exercise his option to sell at $3.15? Let's say next year, the commodity price falls significantly such that similar specialty grade coffees are now selling for $2.50 per pound, by exercising his right to sell at $3.50 the grower has greatly limited his downside risk for next year.
Concurrently, the Grower sells a January 2013 Call Option to the Roaster with a $3.85 strike price and receives $0.35 in proceeds which offsets his/her cost of purchasing the Put. This gives the Roaster the Option, but not the Obligation to purchase coffee next year for $3.85. The Grower also gains the obligation to Sell at $3.85 should the Roaster exercise his right. The Roaster would choose to exercise his right to purchase at $3.85 if the price of similar grade coffees is higher than $3.85, limiting his exposure to even higher prices for a year. The effective result is that Roaster has the Option (but not the obligation) to purchase coffee next year at a 10% increase over this years price. The grower in this scenario will lose the profit potential should the price increase beyond $3.85. Should the price fall instead of rise, the grower has the Option (but not the obligation) to sell coffee to the Roaster at a price 10% below this years price.
The net result is that the exchanged options contracts keep the price within a 20% (10% up $3.85, 10% down $3.15) price range for the next year (2013). If the Commodity price moves vastly higher during 2012, the Roaster can lock in his 2013 Option and buy for $3.85. If the Commodity price moves vastly lower during 2012, the farmer and lock in their January 2013 Option and sell for $3.15. The middle ground is where both parties agreed at the beginning of the year that they wanted the price to be. By creating a specialized Options Contract, the two parties can be certain that under all circumstances that will be the case. If by chance the price remains stable for the year, the options expire and a new contract can be enacted using the same method to achieve stability for the new crop year. The beauty of this model is the spread between the prices which defines the target price for next year can be literally as wide or narrow as the parties desire, and the premiums set accordingly. The premiums can even be structured so that one party pays a lower premium than the other owing to increased risk or asymmetric strike prices on either side of the current price.
In any case the grower foregoes the upside potential beyond the strike price increase, the Roaster foregoes the savings beyond the strike price decrease. Price Stability=Shared Risk= Win/Win
Enacting the proposed structure would greatly benefit from participation of several large independent roasters/importers who are dedicated to farm support and transparency, but also with marketing programs in place to adequately articulate to customers how they are guaranteeing farm income. Alternatively I can imaging an existing Third Party Certifier adopting this type of contract model and branding it as a simple and cheap mechanism to benefit farmers and roasters alike. Remember, the Importer/Roaster benefits from price stability as much as the grower. Last, I imagine that a new legal enterprise could be established to negotiate and monitor contracts with a small net debit premium on each side from the sale of the Put/Call Options and branding the contract something descriptive of it's benefits...The Shared Hedge!
If some Roasters/Importers are currently using Private Options contracts I'd be happy to hear about them, and if anyone is interested in discussing the idea further please let me know.
Showing posts with label Options Trading. Show all posts
Showing posts with label Options Trading. Show all posts
Thursday, April 26, 2012
Monday, December 12, 2011
The BRIC's Will Fall
I wanted to give one last update in 2011 on my running commentary on the Commodity Price for arabica coffee. I have been predicting a drop in price all year and expected the price to approach $2.00 by the end of the year. As I type, the price is $2.2090 and pushing up against the resistance set up at $2.20. Time will tell when it breaks through and accelerates down, but the main reason for my post is to shed some light on the conditions within the BRIC nations (Brazil, Russia, India, China) who were credited early in the year by many "experts" as being the reason demand for arabica was exceeding supply. While I completely disagree with this characterization of their current influence (rather than their potential) I thought I should share some actual data which reduces even their potential impact on the price.
Year to Date, the BRIC nations economic vibrancy as expressed through their Equity Indexes have shrank by the following percentages:
Brazil: -18%
Russia: -23%
India: -23%
China: -18%
Given that discretionary consumption is fed by increases in wealth, and that the relative prosperity of those wealthy enough to invest surplus cash in equities has diminished in BRIC nations, the likelihood that coffee will be able to significantly increase market penetration under these conditions is doubtful. While I have read many experts and publications are predicting coffee will again test the $3.00 level, I'd be very happy to invest against that prediction based on current crop predictions and current consumption levels.
Year to Date, the BRIC nations economic vibrancy as expressed through their Equity Indexes have shrank by the following percentages:
Brazil: -18%
Russia: -23%
India: -23%
China: -18%
Given that discretionary consumption is fed by increases in wealth, and that the relative prosperity of those wealthy enough to invest surplus cash in equities has diminished in BRIC nations, the likelihood that coffee will be able to significantly increase market penetration under these conditions is doubtful. While I have read many experts and publications are predicting coffee will again test the $3.00 level, I'd be very happy to invest against that prediction based on current crop predictions and current consumption levels.
Friday, September 16, 2011
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.
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.
Thursday, August 25, 2011
Trading Coffee Options Contracts
Everyone who roasts, buys, sells, wholesales, pours or grinds coffee needs to have an understanding of the factors that drive the commodity price for coffee. I have posted several times on my predictions for the price of coffee by the end of the year, and the factors that will make those predictions happen. As I type, the "C" has appreciated approximately 18% since the credit downgrade of US debt, and the realization that the likelihood of another recession is increasing. European sovereign debt issues and the search for safe havens for capital have contributed to the appreciation of the commodity price for coffee. These factors were all identified in my earlier posts as game changers for the price to move down, but fear not, what goes up, goes down again. It is with this in mind that I wanted to start a series dedicated to profiting from the volatility of the coffee market, focusing on Options Trading. The reason I want to focus on Options Contracts rather than futures contracts, is that there is much less risk associated with Options, and no need to employ leverage. Options contracts are also very useful when there is a lot of volatility in the underlying commodity. Coffee has been a very volatile market for the past two years, and promises to continue for the foreseeable future. The upside of a well executed options contract is nearly unlimited, but the downside is limited to the purchase price of the Options Contract, therefore you'll never receive a margin call.
Coffee Options are contracts written based on the commodity price of coffee and whose price is derived from the underlying value of the market price. This type of instrument is a derivative.
There are two different types of options, Calls and Puts. And understanding of these terms is crucial to participating in Options trading.
Option Owner Rights:
Call Option holder has the right, but not the obligation, to purchase a specific number of future contracts at a set price (strike price).
Put Option holder have the right to sell, but not the obligation, to sell a specific number of future contracts at a set price (strike price).
Option Seller Rights:
Call Option holder has the obligation to sell a specific number of future contracts at a set price (strike price).
Put Option holders have the obligation to buy a specific number of future contracts at a set price (strike price).
*Selling a Call Option (Put Option) on a Contract you don't own (Naked Call/Put) obligates you to sell at predetermined price and exposes you to unlimited loses if the Commodity Price increases (decreases). Example: Selling a Naked Call Option with a strike price of $2.39, and the commodity price moves quickly to $2.70, you are obligated to sell a contract for $2.39 when you are forced to purchase the contract to cover at $2.70 resulting in approximately $11,000 loss on a single contract. This effectively saddles the Seller with the same downside potential as if you were shorting the contract.
The important thing to remember is that Option Sellers have obligations, Option Purchasers have Rights, but not obligations.
I would recommend purchasing Options rather than Selling (Creating) Contracts. Purchasing Options requires less investment, less downside, with equal upside.
If you expect the price of coffee to increase over the course of time that the contract is valid, you would purchase a Call Option, which becomes more valuable as the price increases.
If you expect the price of coffee to decrease of the course of time that the contract is valid, you would purchase a Put Option, which becomes more valuable as the price decreases.
Options expiration dates occur on the Saturday following the third Friday of each month, which effectively means you have until the third Friday to exercise your rights. I would not recommend trading out of a contract on the last day before expiration as the value of an options contract reduces as it approaches expiration. Exiting an Options Contract is as simple as calling your broker and supplying them with instructions to sell your Option, or exercise your rights.
What I've covered in this post is by no means sufficient to arm you with trading skills, but try to grasp and understand these terms and definitions and we'll expand the topic in a comprehensive way over the next few posts. Next time I'll cover identifying strike prices and costing break even points for Options Contracts using current market prices, and follow some hypothetical trades in real time.
Coffee Options are contracts written based on the commodity price of coffee and whose price is derived from the underlying value of the market price. This type of instrument is a derivative.
There are two different types of options, Calls and Puts. And understanding of these terms is crucial to participating in Options trading.
Option Owner Rights:
Call Option holder has the right, but not the obligation, to purchase a specific number of future contracts at a set price (strike price).
Put Option holder have the right to sell, but not the obligation, to sell a specific number of future contracts at a set price (strike price).
Option Seller Rights:
Call Option holder has the obligation to sell a specific number of future contracts at a set price (strike price).
Put Option holders have the obligation to buy a specific number of future contracts at a set price (strike price).
*Selling a Call Option (Put Option) on a Contract you don't own (Naked Call/Put) obligates you to sell at predetermined price and exposes you to unlimited loses if the Commodity Price increases (decreases). Example: Selling a Naked Call Option with a strike price of $2.39, and the commodity price moves quickly to $2.70, you are obligated to sell a contract for $2.39 when you are forced to purchase the contract to cover at $2.70 resulting in approximately $11,000 loss on a single contract. This effectively saddles the Seller with the same downside potential as if you were shorting the contract.
The important thing to remember is that Option Sellers have obligations, Option Purchasers have Rights, but not obligations.
I would recommend purchasing Options rather than Selling (Creating) Contracts. Purchasing Options requires less investment, less downside, with equal upside.
If you expect the price of coffee to increase over the course of time that the contract is valid, you would purchase a Call Option, which becomes more valuable as the price increases.
If you expect the price of coffee to decrease of the course of time that the contract is valid, you would purchase a Put Option, which becomes more valuable as the price decreases.
Options expiration dates occur on the Saturday following the third Friday of each month, which effectively means you have until the third Friday to exercise your rights. I would not recommend trading out of a contract on the last day before expiration as the value of an options contract reduces as it approaches expiration. Exiting an Options Contract is as simple as calling your broker and supplying them with instructions to sell your Option, or exercise your rights.
What I've covered in this post is by no means sufficient to arm you with trading skills, but try to grasp and understand these terms and definitions and we'll expand the topic in a comprehensive way over the next few posts. Next time I'll cover identifying strike prices and costing break even points for Options Contracts using current market prices, and follow some hypothetical trades in real time.
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