Exciting it is not.
Headline grabbing? Not since last summer’s weather.
But for option sellers looking to generate income, a nice, steady fundamentally driven market may be just what the doctor ordered. Trying to pick “the low” in the stock market may be more exciting but real investors are looking for returns – not fun. Fun can be had on the golf course or at the Super Bowl (maybe), but one’s portfolio may not be the best place to seek one’s “jollies.”
For investors willing to tune out the financial media for a moment, there are still markets out there that are not heavily swayed by credit market fears, interest rate headlines or the latest drama out of Iran. There are still markets out there that rely on old fashioned supply/demand fundamentals to dictate their market price. Investors seeking such a market may want to consider the coffee market when looking for their next premium writing opportunity.
Coffee is one market that is very favorable to fundamental trading. Unlike the equities or bond trader that has to decipher countless government economic data, pour over daily and often contradictory reports, wonder what the Fed is going to do next month and worry about the subprime credit fallout, the coffee investor has to monitor two things – coffee supply and coffee demand.
Fortunately, worldwide coffee demand has remained relatively stable in recent years, increasing at a rate of less than 1% annually. This leaves much of the number crunching to the supply side.
There are a handful of nations that make up the majority of world coffee production. Crop figures and demand estimates are available 6-12 months out and can be projected somewhat accurately. If one can focus on these big picture numbers and tune out the daily "noise", one can compare them to supply and demand of past years and their corresponding price levels. This may not tell us exactly where the market is going to go. But it can give one a fairly clear idea of where the market most likely will not go. And as option sellers, that is all we need.
Brazil is the world’s largest producer and exporter of coffee and is responsible for approximately 1/3 of the world's total coffee production in any given year. It accounts for the majority of the higher quality Arabica coffee traded at the Nybot (now ICE). Thus developments in the Brazilian crop have a substantial impact on coffee futures prices at the ICE. Brazil grows more than three times as much coffee as Vietnam, the world’s second largest producer. Vietnam, however, produces primarily the Robusta variety of coffee traded in London. It is Brazil that meets the majority of everyday global Arabica demand and therefore developments in its crop have a major impact on prices at the ICE. This is also why at times there appears to be a substantial difference in values between ICE and LIFFE coffee prices.
Brazil experiences an every other year "on/off" cycle in coffee production where higher production years are usually followed by lower production years. This is a natural cycle of coffee trees. 2006 was an "on" year for coffee production. Brazil produced nearly 42.5 million bags of coffee. This resulted in a small world coffee surplus for the 2006 crop year.
The year 2007 was "off" for Brazilian coffee growers. Brazil produced approximately 33.7 million bags of coffee. Prices adjusted accordingly in 2007 and now trade at a price approximately 15% higher than last April’s pre-harvest lows.
The big story, however, is the 2008 Brazilian crop. Because of moist conditions for much of 2007, coupled with an upcoming "on" year for harvest, many coffee analysts and industry panels are projecting 2008’s Brazilian harvest to be substantially larger than that of 2007. Official Brazilian government estimates peg the upcoming 2008 coffee crop somewhere between 41.3 and 44.2 million bags. The Brazilian Ag ministry’s forecasts, however, have historically been roughly 10% lower than the actual figure and most traders now factor in such short counts. Widely respected independent analysts Safras e Mercado sees the 08 crop coming in between 47.6 – 49.9 million bags. The Liberty Trading/OptionSellers.com official estimate in last week’s Reuters survey was 49 million bags.
An ‘08 Brazilian crop of 48 million bags would be the second largest on record and have a substantial impact on the balance of world coffee production vs. consumption. In 2007, world production reached 121.8 million bags while world consumption was seen at 124.0 million bags. This resulted in a 2.2 million bag deficit for the year – which was widely reported in the press and is largely responsible for coffee’s current price range remaining north of $1.30 per pound.
That could change soon.
With Brazil’s larger production, world coffee output is expected to reach 133.25 million bags in 2008 while global consumption is seen at 126.0 million bags. If these figures are realized, it will result in an 8.25 million bag surplus for the 2008 crop year.
Coffee traders are well aware of 08 production estimates. The specter of this figure looming over the market should be enough to keep the bulls in check for at least the first half of 2008. In addition to pricing in larger supply in the coming months, the coffee market is also entering what is typically a “quiet” time of year for prices. Volatile moves in coffee prices are usually the result of weather and most often, Brazilian weather. June through August is Brazilian winter and traders are often edgy about freeze fears. October is flowering season, a critical stage for the upcoming crop. However, the 2008 crop has emerged in relatively good shape from both of these fire tests. The next several months are typically mild in Brazil and not known for major weather events. Thus, from now through the beginning of harvest (May), prices should be mostly focused on pricing in the 2008 crop.
If this market follows its fundamentals, that should mean steady to lower prices.
Our recommended strategy is selling far out of the money calls well above the current market price in 2008 coffee contracts. Supply fundamentals are bearish and the market has not yet fully priced in the 2008 surplus. More importantly for call sellers, we see little that could cause this market to rally substantially in the coming months and thus, this should set an ideal stage for sellers of call premium.
Remember, as an option seller, you don’t have to pick where the market is going to go. You only have to pick where it is not going to go. At this time, we see strikes available in mid ‘08 coffee contracts that should solidly meet this criterion.
In our opinion, it makes a lot more sense than putting the value of our investment portfolio in the hands of Ben Bernanke.
Figure 1: May Coffee 08
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
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