Freeze-driven Coffee Bull? Try decaf & write calls

October 29, 2017 04:02 PM
Coffee’s recent rally during an off-year crop and hints of freeze hysteria are producing elevated options premiums and opportunities.

Buy it All for a Freeze?
It used to be that coffee traders got excited about going long coffee ahead of the Brazilian winter. A series of high-profile freezes in the 1990s and early 2000s made this an annual event. Coffee prices often rallied even without any weather threat at all, simply off of public participation in the annual chance to strike it rich. If a freeze decimated the coffee crop, the holders of futures contracts would make a bundle. But Brazilian coffee farmers grew weary of spinning the annual roulette wheel. Beginning in the mid-2000s, replacement trees planted to supplant early frost losses were planted further north, closer to the equator in warmer climates. With up to 30% of Brazilian production moved all but out of harm’s way, the freeze phenomenon became less of a factor.

Seasonal tendencies show that despite a lower potential for freeze, Brazilian mid-winter from June through September can often see a spike in coffee futures (see “Coffee buying season,” above). A secondary spike—and an opportunity for higher premiums— can also occur during flowering season in the Brazilian Spring (October).

That doesn’t mean it went away entirely. Cold weather talk, which recently hit this South American winter, can still bring out the buyers in the coffee market. In fact, weather buyers were a primary driver of the recent 26% price surge in the coffee market (see “Something brewing,” above). But the chances of a Brazilian hard freeze causing significant damage to the coffee crop have dropped substantially in the last 10 years. Thus, weather rallies during the Brazilian winter often can be shorting opportunities and an exceptional time for call writing in coffee.

2017 Fundamentals
Coffee bulls made quite the big deal about 2017’s “off” year in the Brazilian production cycle. Yet estimates for the 2017 Brazilian harvest range between 49-51 million bags of coffee. This is the largest “off” year harvest on record and is only 4-to-6 million bags shy of last year’s record 55 million bag harvest.

That’s not the bull’s biggest challenge, however. As of Aug. 1, the 2017 Brazilian harvest was 80% complete vs. 76% at the same time last year. As harvest nears completion, the focus will begin turning toward next year’s crop. By most accounts, it’s expected to be a whopper.

While the numbers will come more into focus after flowering, early estimates put the 2018 Brazilian coffee harvest at 58-62 million bags. This due to an “on” year in production as well as to a fair degree of pruning done to trees this year, which tends to help trees bear more fruit the following year.

If the forecast is realized, 2018 will be an all-time record for Brazilian coffee production.

Lastly, U.S. green coffee warehouse stocks are now at all-time record levels – largely overshadowing the bulls’ argument of a 2017 global coffee deficit.

Freeze dried coffee rally
The bulls continue to tout the lower 2017 Brazilian coffee production and a 2017 global coffee deficit as reasons to buy the market. Let them.

Despite this, 2018 is shaping up to be an oversupplied year for coffee. In addition to a potential record crop out of Brazil, Vietnam—the world’s second largest producer—is expected to harvest 10% more coffee next year than it did this last.

With seasonal factors now also appearing to shift in the bear’s favor, and call premiums elevated after the July/August rally, the time is right to consider layering on short coffee call positions for early 2018 expirations.

Traders can stagger a series of short calls strikes above the early 2017 high of $1.70. Self-directed traders can consider the March 2.00 call on further rallies this month (see “October showers bring March flowers,” above). Target premiums are $400 to $500 per option. There should be strong resistance at the 2017 high and March contract high before hitting the psychologically important $2 level. Should no such rally occur, traders can consider moving out to the May contract where the same strike currently offers premium in excess of $550.

It would likely take an unforeseen and substantial weather event to eventually push coffee prices to $2 per pound. With the end of Brazilian winter approaching, the chances of such an event decrease daily. Risk of loss, of course, is still present in any trade and thus, risk parameters should always be adhered to.

However, the current margin requirement to premium ratio projects a 43% return per option should the options expire worthless. That’s getting paid pretty well to bet against the improbable.   

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About the Author

James Cordier is the founder of www.OptionsSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. He is the author of The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014).