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Coffee exchange in the midst of coffee options explosion.

Expectations were modest when options on coffee "C" futures trading opened at the Coffee, Sugar & Cocoa Exchange, Inc. (CSCE) in October, 1986.

"Our hope was that coffee options volume would amount to about 10% of coffee "C" futures volume," recalls James Bowe, CSCE senior vice president for market development and planning. "Over time, we aspired to reach a point where options volume would fuel futures volume, which in turn would trigger more options volume."

While Bowe and other Exchange officials were confident they had a good product, few could have imagined the market's dramatic growth since its inception five years ago.

Annual contract volume through November of this year stood at 378,339 contracts--about 22% of coffee futures trading. Moreover, the 1991 figures represent a 33% gain over total 1990 options volume and a 1,375% increase over 1987.

Open interest has also grown by leaps and bounds. In October, month-end open interest stood at 44,950 contracts, almost 2.4 times greater than coffee futures open interest in October 1986 when options began trading.

"The driving force behind the growth is knowledge: what traders don't know about prices and what traders do know about risk management," Bowe said. "With the state of the coffee market today, traders have no way of knowing price direction with any degree of certainty. At the same time, more and more traders have learned how to use options as a powerful tool to manage that uncertainty."

Since the ICO agreement collapsed and prices plummeted in 1989, the coffee market has been plagued with uncertainty. Lingering potential for a new agreement and periodic changes in growing conditions have only exacerbated the situation.

"The market is much more volatile," said Judy Ganes, senior softs analyst at Merrill Lynch. "With the price supports (under the agreement), traders had price parameters. Now, with a free market, there is much greater risk exposure."

The dilemma for the coffee trade is managing risk without sacrificing the ability to participate in favorable price moves. Options provide the necessary flexibility -- providing protection at a known cost.

For example, a coffee roaster seeking to guard against rising green coffee prices can buy calls. Downside risk is limited to the premium paid. On December 12, March coffee futures settled at 79.05 cents/pound and March 80 calls at 2.58 cents/pound. By purchasing the calls, the roaster is protected against price increases beyond 82.50 cents/pound (strike price plus premium paid). If prices do not rise, the most the roaster can lose is 2.58 cents/pound, positioning him to enjoy the benefits of obtaining green coffee at a lower cost. If the roaster were to purchase futures instead of calls, he would face unlimited downside risk, precluding participation in favorable price moves.

Further, given the wide selection of strike prices available, a roaster can vary risk protection. As with automobile insurance, the lower the premium paid, the greater the price move before coverage is activated--in other words, the higher the deductible.

"Options are a great way to take risk out, you can use them like disaster insurance," said W.C. "Dub" Hay, a vice president at Nestle Beverage Company and chairman of the CSCE Coffee Committee. "With options, you know what you are getting into. It opens up a vast array of possibilities for us."

Hay added that for large coffee companies, options are the most effective vehicle for hedging the sale of finished coffee as well as the purchase of green coffee. Using options, it is possible for a coffee marketer to make an attractive guarantee: a ceiling price for finished product without taking away the opportunity to pay less if prices fall.

Moving up the Learning Curve

The introduction of coffee options trading brought with it new terminology, mechanics and strategies to digest. It has taken some time for the community to become comfortable with the concept.

"It has taken time to get used to options," Hay said. "It is a whole different language. People had to try a few trades before they could get active and creative."

Now, options are a standard component of the trade's risk management arsenal.

"Options are entrenched at each point in the marketing chain," Bowe said. "It has reached a point where cash market contracts are written to guarantee producing countries minimum prices for green coffee that are backed by options purchased through the Exchange."

"People are definitely more comfortable using options along with their futures and cash market strategies," Hay said. "It was the best introduction in soft commodities that we could have possibly had. And, that is reflected in growth--everyone is using options."

Even as the market continues to grow, the CSCE is seeking ways to enhance option market utility. One modification set for introduction on January 3, 1992, is the reduction of strike price intervals when futures prices are less than 100.00 cents/pound.

Currently, strikes are set at five cent/pound intervals. Under the new program, those strikes intervals will be reduced to 2.50 cents/pound.

"In the call market today, if the underlying futures price is 87.50 cents/pound, traders are forced to choose between an 85 call that might be too far in-the-money and a 90 call that is possibly too far out-of-the-money," Bowe said. "With the new intervals, traders will have more close-to or at-the-money selections...in this case, an 87.50 strike. It is a minor change that can make a major difference for some traders."

As for further growth, Bowe's goals are decidedly less modest today than they were five years ago.

"I would like to see options open interest eclipse futures open interest," he said. "However, the target is elusive because of the options-futures-options cycle we have been successful in creating. We are quite happy to fall short (of that goal) if it's because futures keep growing as they have in the past few years." [Graphs Omitted]
COPYRIGHT 1992 Lockwood Trade Journal Co., Inc.
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Title Annotation:coffee market
Author:Plourd, Philip G.
Publication:Tea & Coffee Trade Journal
Date:Jan 1, 1992
Words:988
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