Over-Priced Call Options Now in Coffee Market
Arrival of “Rainy Season” in Brazil Offers Fundamental Opportunity for Option Writers Seeking High Premiums
With the Election now behind us, mainstream investors now find themselves fretting over which way stocks will ultimately move, how interest rates will react and if that REIT they bought last week is still such a good idea.
For some relief from election related portfolio guessing, you need look no further than the commodities markets, where supply and demand continue on, regardless of who sits in the Oval Office. Fundamentals are king in commodities and each market has its own, unique blend.
A perfect example right now is the Coffee market, where opportunities for income generation from writing options seem extraordinarily ripe.
Coffee prices have been in an impressive uptrend as lower Robusta production and the approach of Brazilian flowering season have kept forward buying strong.
The El Nino weather pattern brought drier weather to both Brazil and Vietnam, hurting yields especially in the Robusta crop. But the market has been floating on the Robusta story for a long time. A variety of factors may now be combining to take the wind out of the bullish sails.
Dryness in Brazil and Vietnam curbed 2016 coffee yields – a major factor in the current price rally. However, with the arrival of flowering season in Brazil, the trade will turn attention to next year’s crop.
Most important of these is the time of year. It is not uncommon for coffee prices to rally ahead of “flowering” season in Brazil, which they clearly have done. Flowering is when the coffee trees produce tiny flowers that fall off, leaving a “cherry.” This cherry is what matures into a coffee bean. Flowering season is the most critical time of year for next year’s coffee crop. Anxiety can build amongst traders in the weeks and months leading up to flowering season – often resulting in price strength. Weather speculation is rampant. Dryness in September was especially concerning this year – a big factor in the latest leg of the rally.
However, as flowering occurs (typically in late October and November), anxiety fades from the market – often dragging prices back down. (A similar phenomenon occurs during planting season in the US Grain markets.)
Flowering tends to coincide with the arrival of the “rainy season” in Brazil. Thus, September and October are usually dry in Brazil. However, the arrival of timely rains late in October hints that weather patterns are now shifting to their typical seasonal patterns. In fact, with the El Nino now shifting to La Nina, a wetter pattern could now be in store for Brazilian growing regions into the spring. Brazil’s CCCMG Coffee Exchange confirmed last month that recent rains have indeed gotten 2016 flowering underway.
Regardless, the price tendency that tends to accompany the arrival of the Brazilian rainy season (and thus flowering) is illustrated in the seasonal average chart below”
A successful coffee flowering season in Brazil has tended to bring relief to nervous traders and thus, lower prices in Coffee. While this chart reflects an average, flowering can occur as early as September and as late as December.
2016 could be an especially ripe flowering season for call sellers. Robust moisture levels can allow trees to flower 2 or 3 times, producing up to 20% more beans than a dry year. (If you would like to hear more about the current situation in coffee and a suggested strategy you can use for high premium, be sure to catch our October 21st Radio Show at www.OptionSellers.com/Radio.)
While its too early to estimate the size of the 2017 crop, selling calls during Brazilian flowering season has historically been a fundamentally and seasonally sound strategy.
We’ll be working closely with managed portfolios in selecting and staggering across a series of strikes and optimal contract months.
Non-clients can consider selling the May Coffee (KCK) $2.40 call currently offering premium of $562. The volatility in coffee also makes it a prime candidate for credit spreading. (Note: Commodities option values are listed in points. Every point in coffee is worth $3.75. Thus, an option reflecting a value of “150” is actually a cash value of (150 x 3.75) $562.)
May 2017 Coffee
May Coffee showing the $2.40 call strike. Coffee offers exceptionally deep out of the money strikes which should make it a favorite in your option writing portfolio.
Note that by selling this far out of the money, you are not necessarily trying to pick a top in coffee prices. You are only selecting a point where the market is unlikely to go. The coffee market has traditionally offered exceptionally deep out of the money strikes. This should make it a favorite of a well-balanced option writing portfolio.
The potential return is also attractive. With a margin requirement of approximately $1230, the return on capital is 45.7% at worthless expiration. If $562 does not sound like a lot of money, remember, you can sell these by the dozens. Or, by the 100’s, depending on your capitalization level. (Note: These types of numbers are what separate “play” from serious investment. Investors taking in this kind of premium are advised to have professional assistance.)
Making Your Investment
Investing in markets like these, despite making good conversation on the golf course, can be intimidating to some investors new to the asset class. Just remember that these are simple products that we all use every day – and that some people trade every day. It’s simply a matter of familiarizing yourself with them. By reading this letter, you already know more about them than 95% of the investing public. However, the guiding hand of a professional can also be a valuable asset to those not willing to take the plunge themselves.
We’ll be updating potential opportunities in other softs markets prior to years’ end. For now, remember that they’re unlikely to be trading in tandem with coffee. And they are certainly unlikely to correlate AT ALL with equities. If you’re worried about the current state of the stock market, that already makes them a winner.
James Cordier is author of McGraw-Hill’s The Complete Guide to Option Selling, 3rd Edition and head portfolio manager at OptionSellers.com – a wealth advisory firm specializing in option writing portfolios for high net worth investors. James’ trademarked Premium Sniper investment program has been used by elite investors from the US, Australia, the United Kingdom, Singapore, Malaysia and Dubai. For more information visit www.OptionSellers.com/Discovery.