Coffee Market Remains Fertile Ground for Option Sellers

Name: James Cordier & Michael Gross Company: Liberty Trading Group

Years Trading: 25

Author’s note:
I’d like to start this week’s article by thanking the readers of our newsletter (public and proprietary editions) for your positive feedback on our last two articles.  I hope you were able to profitably utilize some of the knowledge therein.

As for the gentleman who suggested a more “directional” market focus in upcoming articles, I’m glad you gave us an opening to make a key point.  The purpose of this column is not to tell you which way the market is going to go (in fact, if you find somebody that can do this, please let me know).  The purpose is to show you how to make money selling options.  As successful option sellers know, the short term direction of the market is often irrelevant to the ultimate success of the trade.  As an option seller, you don’t have to predict where the market is going to go. To be successful, you only have to find a point where prices are not going to go.
But, we’ll go easy on this guy. I’m sure he’ll catch on in a few weeks. –JC

Commodities prices in general have leveled off in Q1 2009 and have even started showing some strength in some sectors. Precious metals such as gold (see Gold still Golden for Option Sellers 1-19-09 at www.libertytradinggroup.com/commentary.html) have been particularly strong while agriculturals such as soybeans and coffee have experienced some limited rallies. More industrial commodities such as copper and natural gas continue to languish near (but not broken) the lows.

While far from a bull market, the downside trends are, at least temporarily, broken. This is impressive only in that it occurred under the current macroeconomic conditions. Global demand for most every commodity continues to stagnate if not outright decline. The US dollar has (up until yesterday) stubbornly refused to halt it’s advance. These two factors alone have put much pressure on commodities prices.

So why are prices firming up? 

It appears that fund players have come back to commodities over the past 6-8 weeks. Many funds are “long only” funds and therefore (like a mutual fund) have to buy something to get in the market – get their investors “positioned.”  We’ve seen sporadic buying across the board during this time period and there is some fundamental justification. While the US dollar has continued to push higher as of late (due almost exclusively to the fact that the rest of the world appears to be worse off than the US), this week’s surprise move by the Fed to buy US treasuries was a blow to dollar bulls.  How this plays out of the next couple of week’s remains to be seen. However, many traders are looking out 6-9 months in the future and see a spiraling deficit, mammoth US debt and an expanding money supply – none of which would bode well for the US dollar. After all, this is the futures market and traders tend to focus on the future.  A weaker dollar would be supportive to commodities prices.

But before you call up Jim Rodgers and buy into his commodity index fund, consider this: commodities are going to need more than a weaker dollar to begin a new bull market. Dollar weakness would support prices, no doubt. But before a sustained uptrend can begin in earnest, global demand is going to have to come back to the table. And at the time of this writing, global demand for most commodities is still contracting.  This will keep a lid on any new bull markets in most sectors (with the possible exception of gold, where investor demand has been steady, if unspectacular). In addition, there is no guarantee that the dollar will immediately dive into a bear market, despite the active hand of the Fed.

With this macroeconomic picture as our backdrop, we will focus this week’s Option Selling commentary on a market not always associated with Federal Deficits and Monetary policy. The Cofee market is a pure agricultural commodity that, refreshingly, takes much of it’s price direction cues from good old fashioned supply and demand.  In our commentary back in October (See A bull in a bear market 10-30-09 at www.libertytradinggroup.com/commentary.html) we stated that coffee prices may not move absolutely higher, but that they would outperform commodities as a whole, moving slower in a continued bear market and faster if commodities began to trek higher. A strangle strategy would have been a good way to bank steady premium over the last three months. Coffee is now back near the same price level it was at the time of that writing. And we must once again examine if this is still a good place to put monthly premium in your account.

The answer, in our opinion, is yes, it is. Fundamentals still support the viewpoint that this market does not have the horsepower to run away. Yet, volatility is higher than it was in October, making it a fertile ground for selling options.

Coffee Fundamentals

As the world’s largest producer and exporter of coffee, Brazil remains a focus when analyzing coffee prices. As we have discussed in past coffee articles, Brazil experiences an every other year “on/off” cycle in production. “On” years produce more beans, “off” years produce less. The 2007/08 harvest produced 46- 48 million (60 kg) bags of coffee.  The 2009 Brazilian harvest is expected to total nearly 38 million bags.

Coffee has experienced some price strength over the past 6-8 weeks primarily as a result of the fund buying mentioned above, pricing 2009’s smaller crop, and a media story circulating lately about a “shortage” of beans.
The shortage, however, is not in the main supply of Arabica and Robusta beans. The shortages have occurred in the “premium” stock of beans, much of which is grown in smaller niche suppliers such as Columbia (where production fell 9% this year) and Costa Rica. The “group of nine” which includes Mexico, Columbia, the Dominican Republic and others, saw exports drop 16% year on year for the month of December. Much of this was due to heavy rains in certain regions and a crop rejuvenation program that hampered some short term production.

“Premium” coffee beans are used primarily in gourmet coffee brands served in upscale restaurants and coffee shops. A small percentage of the ICE coffee contract is made up of premium quality beans. However, with the media coverage of the shortfall in this niche market, it has been enough to help support coffee prices as of late.

Our view: It won’t last. Past recessions have shown that overall global coffee consumption only decreases slightly during economic slowdowns. However, demand for the higher priced gourmet beans falls dramatically, as populations forego gourmet blends at restaurants, opting instead to make their own pot of Folgers at home.
Establishments such as Starbucks are seeing a sharp drop in demand and this decline is expected to deepen in 2009. It should only be a matter of time before slumping demand makes the premium blend “shortfalls” disappear. Any slight uptick in demand for lower quality beans will be more than offset by adequate if not a burdensome supply of these blends.

For in the overall coffee supply figures, leftover stocks from the 07/08 crop year combined with larger crop takes in producers such as Vietnam (20% production increase in 09) have all but offset the lower supplies from Brazil and Columbia. Globally, at 136.2 million bags, world coffee production is down slightly from last year, but more than adequate given global demand trends.

World coffee production in 08/09 is expected to exceed consumption, resulting in a coffee surplus for the year of 8.77 million bags. This is will be the second straight year of coffee surpluses and continues to paint a picture of burdensome supplies in 2009.

Fundamentally then, coffee would not seem to have a justification for a sustained rally anytime soon, with hefty supplies keeping pressure on limited rallies that may result from fund buying or currency fluctuations.

Investment Strategy

While it is certainly possible for prices to rally another 5, 10 or even 15 cents, we believe that calls strikes now available at nearly double the current price of coffee should make solid premium collection opportunities at this time.

We like staying with the July and September contracts as they still are “old crop” (08/09) contracts and will not be as affected by any issues that might arise regarding the (2009/10) crop.

We will be working closely with clients in positioning in the coffee option market over the next 7-10 days. The recent price strength should offer a good opportunity for doing so.

If you would like more information about selling options in the coffee market or building a portfolio based on the option selling approach, feel free to call us at 800-346-1949 or visit us on the web at www.OptionSellers.com and request a free Investor Information Pack.

James Cordier
Michael F. Gross
OptionSellers.com

800-346-1949
813-472-5760 (International)

James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in option writing portfolios. James’ market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News, Bloomberg Television News and CNBC.  Michael Gross is an analyst with Liberty Trading Group/OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.

About the Author

Mr. Cordier and his firm specialize in option writing and have developed a strategy of selling out of the money options on futures contracts that they share with clients of their brokerage. Cordier’s book, The Complete Guide to Option Selling (McGraw-Hill 2005) has inspired a generation of investors, was released in China in 2007 and is scheduled for re-release in a second edition later in 2009.

James' study of the commodities market began at age 14 when a silver coin collection sparked his interest in silver futures. He began his career at Heinold Commodities in Milwaukee as a broker in 1984. Several years of working with commercial business enabled him to not only build a solid knowledge base of market fundamentals but also establish of network of producers and end users that remains in place today.

In 1991 James began an eight year association with Allendale, Inc. in Chicago where he began publication of his newsletter, the Cordier Report. Success at Allendale eventually led to his own branch office in St. Petersburg, FL.

In 1999, having established a solid reputation and a certain level of notoriety within the industry, James founded Liberty Trading Group.

Despite giving market commentary to news outlets and financial websites and co-authoring The Complete Guide to Option Selling (Mcgraw Hill 2005), James still works directly with most client equity and never underestimates the importance of staying in close contact with his clientele’ on an individual basis.