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On the Market.

On the Market

On April 18, 1990, Judy Ganes, senior analyst at Merrill Lynch Futures, stated her outlook for coffee futures prices. She said, barring a new ICO agreement or a freeze in Brazil, prices are expected to be weaker finding support at 90-92 cents/lb. with futures trading in a tight range. Ganes believes recent Brazilian economic measures and lack of shipments helped drive prices towards $1.00/lb., but she expects strong producer selling at $1.02 - 1.04 to cap the recent advance. According to Ganes, seasonally, the peak consumption period has passed and as Brazilian shipments resume, prices are likely to be weaker once again.

We asked Beverly Gordon, vice president of marketing and communications at the Coffee, Sugar & Cocoa Exchange, how a roaster might use options considering this market opinion.

If you believe that coffee prices will trade in a narrow range over the near term, writing call options can be profitable from several perspectives. The seller (writer) of a call option agrees to sell a coffee futures contract to someone else at a set price (strike price) for a specific period of time. In exchange for granting that right, he receives a premium.

In previous articles we have discussed how writing calls against an inventory of coffee can, under some circumstances, achieve the equivalent of an above-the-market selling price, be considered as reducing the cost of inventory, be viewed as an offset against the cost of carrying the inventory, or still yet as as a partial hedge against a price decline.

This article will discuss how call options can be written against existing futures positions (covered calls) to achieve a potentially higher selling price while at the same time providing a "cushion" in the event that the futures prices decline.

For example, suppose a roaster bought September '90 coffee futures this past February 1, at the settlement price of 85.75 cents. His purpose was to "lock in" at what he believed was a favorable price in order to satisfy anticipated fall inventory needs. As of April 18, his forecast has proven correct with the settlement price of September coffee futures rising to 97 cents. This gives the roaster an unrealized profit of 11.25 cents or $4218.75 per contract (37,500 lbs. x 11.25 cents).

One alternative, of course, would be to sell the futures contract and take the profit. However, according to the marekt opinion the price of coffee could still increase to the $1.02 - $1.04 level. Of course the risk of a decline to the 90 - 92 cent level must also be considered because the roaster would like to protect his unrealized profit. Let's examine the feasibility of writing calls against the futures position to capture some additional upside potential, while at the same time protecting against a possible decline. Since options on coffee futures are listed at 5 cent intervals, and September futures settled at 97 cents on April 18, the roaster would have to choose between writing the 95 cent option that is slightly in-the-money (strike price below the current market price) or the 100 cent option that is slightly out-of-the-money (strike price is slightly above the current market price).

If he agrees with Ganes' opinion that the market has a slightly bearish bias, he might choose to sell the slightly in-the-money September 95 cent calls on April 18, and receive a premium of 8 cents representing 2 cents in intrinsic value + 6 cents time value (intrinsic value is the amount the option is in-the-money). September options expire on August 3, 1990.

If the futures price is above 95 cents at expiration you should expect the call will be exercisd, and his effective selling price will be the strike price of 95 cents plus the 8 cent premium he received or $1.03 per pound.

On the other hand, if the futures prices were to decline to 95 cents or below at expiration the option will not be exercised and the option premium would offset 8 cents of the decrease. If futures prices declined to 89 cents, for example, the roaster would still be able to realize the same 97 cents (89 cents + 8 cents premium) as he would have realized by liquidating the futures position on April 18th.

The writing of covered call options is thus most appropriate when you have a basically "steady" market opinion. Slightly bearish or bullish biases can be accommodated by the use of in-the-money or out-of-the-money strike prices. If the roaster in our example thought coffee futures prices would fall precipitously, he would probably elect to liquidate his futures position. Conversely, if he were strongly bullish, he would not elect to limit the chance for dramatic profits by writing call options.

However, if the roaster agrees with the market opinion given above, writing covered calls can be a valuable technique to protect unrealized gains from profitable futures positions while at the same time trying to achieve some additional return in anticipation of purchasing fall inventory.
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Title Annotation:Judy Ganes views coffee future prices
Publication:Tea & Coffee Trade Journal
Date:May 1, 1990
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