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Fundamentals. Commodities option selling should always start with the market fundamentals. Ultimately, prices will have to respond to them.

There are times, however, where prices will stray from fundamentals - off into their own direction, generally in response to external factors or market sentiment. When they get too far off track, the fundamentalist can make his move. Futures traders are often forced to accept a technical model of trading, for being wrong by a day or two is often the difference between a winning and losing trade.

Option sellers, on the other hand, can focus on fundamentals and not be as concerned with daily price movements. By positioning in strikes far above or below a market, the option seller is primarily concerned with where prices will not go over the long term - a strategy that seems almost perfectly conceived for trading market fundamentals.

Coffee prices at New York's ICE have seen an impressive push higher over the past several weeks. While technicians will point to breakouts and moving averages, these things only reflect what is happening fundamentally. ICE coffee is rallying for two reasons.

1. Near term tightness in high quality light Arabica beans (which are used to deliver against ICE contracts) has been a continuing theme as of late. As Brazil is at the end of its annual crop year, it becomes a time of tighter supply on the global market for Arabica blends. While Brazilian beans are not deliverable against the ICE contract, global tightness for Arabica means smaller producers such as Columbia and Costa Rica (which DO deliver against ICE contracts) have become stretched.
2. The US dollar's steep decline has been adding upside support to many commodities traded on US exchanges. As the dollar depreciates, US traded products become more expensive. ICE Coffee is no exception.
3. The coffee market tends to price in a "freeze premium" in May ahead of the Brazilian winter which begins in June. While freezes typically have little impact on this year's harvest, they can damage coffee trees for next year's crop.
4. But there comes a point where short term squeezes run into big picture realities. There is no shortage of global coffee. A look at coffee prices in New York and coffee prices in London, seem to show that the US dollar's influence has adjusted ICE prices beyond what the rest of the world is paying (see Figure 1 below).

Figure 1: Brazilian Green Coffee Production
Graph courtesy of Hightower Research

The dollar influence and near-term Arabica tightness will soon run into a worthy counter-weight, however. In June, Brazil, the world's largest producer and exporter of coffee (typically accounting for 35-40% of total world production), will begin its 2009 coffee harvest. If you read The Complete Guide to Option Selling (McGraw-Hill 2005), you know that harvest time in agricultural commodities is when supplies become most ample, as new crop product floods the market.

Brazil is expected to harvest upwards of 39 million bags of coffee this year. While this is an "off" year in the every other year Brazilian production cycle, and lower than last year's estimated 51-million-bag crop (Brazil reports 46 million bags), 39 million bags is a fair sized crop by historical standards - especially in an "off" cycle year. Regardless of crop size, prices have historically responded by moving lower through the June-August harvest period which, coincidentally, also corresponds with lower coffee consumption cycles in the northern hemisphere as summer arrives.

Brazilian producers are well aware of these cycles and will typically try to wait for the highest prices prior to harvest before hedging their crop. This commercial selling has been thus far absent from the market. This has helped prices to push higher unhindered. If prices begin to show signs of ebbing, however, look for commercial selling to enter the market in a big way as producers rush to get their crop hedged.

While there is no guarantee that prices will move lower this year (past performance not indicative of future results), it does appear that Brazil will be harvesting this year and it does appear as though summer will arrive in the northern hemisphere.

There are coffee calls now available in the September contract at strikes nearly double the current price of coffee. The recent rally (also a common occurrence in May as supplies from last year reach their lowest levels) has helped inflate call option values. Aside from being so deep out of the money, these calls are attractive because September options should be entering a "sweet spot" of time decay over the next 30 days - as they expire on August 14th.

Freezes are always a possibility in Brazil during winter months. But the program of moving production areas further north (towards the equator) over the last 10 years has substantially reduced the chances of crop damage and thus 1990s-like price moves that many coffee traders remember. Even in the unlikely event of a freeze so far north, global storage levels are much higher now than they were in the late 1990s, making prices less sensitive than in the days of yesteryear.

There is nothing to indicate that this week marked a high in ICE coffee prices. The dollar's continued plunge lower will be a supporting factor to physical US commodities, should it continue. However, there are enough bearish clouds on the coffee price horizon to make us quite comfortable selling options that are 100% out of the money. The Coffee market advance will begin to run into bearish resistance as Brazilian beans arrive on the global export stage, relieving the pressure on smaller Arabica producers and slowing, if not reversing the recent price advances.

We at Liberty Trading will be working with client investor portfolios in the coming 7-14 days in the positioning of this trade.

Figure 2: Sept 09 Coffee

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/Optionsellers.com
Optionetics.com ~ Your Options Education Site

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