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On the market.

On the Market

The last article discussed how to hedge against a possible sharp decline in coffee prices by buying put options. In this article Beverly Gordon, vice president/marketing & communications of the Coffee, Sugar & Cocoa Exchange will discuss the opposite situation, how to hedge against a possible sharp rise in coffee prices by buying call options.

With the breakdown of an agreement of the International Coffee Organization, (ICO) prices for the Coffee C spot contract dropped from around $1.35 per pound during the end of May to under $.70 by the middle of October, a drop of almost 50 percent.

The question can now be asked if there are any strategies that a roaster can use over the next few months for protection against a sharp rise in prices should a new agreement of the ICO be reached. If we were certain of that event happening, roasters could simply buy futures. However, this could be risky, if we should be proven wrong.

Buying call options is a much safer way to hedge against a rapid advance in coffee prices. In exchange for a premium, the buyer of a call option receives the right buy not the obligation to take a long position in the futures market at a given price (the strike price) for the term of the contract. However, if prices remain the same or continue to erode, the holder of a call option can simply let the contract expire, and the most that will be lost is the premium dollars.

As with insurance, a bigger premium will purchase more protection, along with less exposure. However, with the uncertainty surrounding the signing of a new agreement, a roaster may not be willing to pay the premium dollars required for the full protection at-the-money call options (strike price of the option equal to the current futures price) would buy. In that case, he may wish to protect against a major price rise by purchasing less expensive out-of-the money call options (strike price of the option is above the market price of the futures). This strategy is similar to purchasing an insurance policy with a deductible. The table below compares prices for March '90 call options.
 Break Even
Strike Price Premium Cost/ Protection level less
 (in cents) Total Risk in cents cost in cents
 70 $2,925 (7.80 [cents]) above 70 77.8
 75 $2,096.25 (5.59 [cents]) above 75 80.59
 80 $1,511.25 (4.03 [cents]) above 80 84.03
 85 $1,162.5 (3.10 [cents]) above 85 88.10
 90 $ 742.50 (1.98 [cents]) above 90 91.98

* each contract is for 37,500 pounds of Coffee "C" the cost per contract is 37,500 X the settlement price

As can be seen from the table above, it costs only $742.15 to purchase an out-of-the money March '90 call option with a strike price of $.90, compared to the cost of $2,925 for an at-the-money option of the same duration. However, one can readily see the difference in the break even levels. As the out-of-the money amount increases, the premium cost decreases, while the deductible or exposure level rises.

The strategy of buying call options to protect against a rapid rise in prices is the mirror image of buying put options to protect against a rapid fall in prices. In both instances a roaster must decide how much protection he needs and the amount of the premium he is willing to pay. The graphs below reflects the profit/loss characteristics of a long call and long put.

Next month's article will discuss how to use the options market to finance inventory costs if the price of coffee is expected to remain the same.
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Title Annotation:buying coffee commodity call options
Author:Gordon, Beverly
Publication:Tea & Coffee Trade Journal
Article Type:column
Date:Nov 1, 1989
Previous Article:Physio-chemical and structural characteristics of "espresso" coffee brew.
Next Article:More competition ups Kenya's tea prices.

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