Coffee Futures: A Bitter Trade?

Right now, we have selling signals for coffee futures since August 20, 2009, and from our trend following bias, we suggest shorting the "C" Futures, 37,500 pounds of arabica beans per contract, available on ICE, the new home for the New York Board of Trade, or NYBOT, contract. At the time of this writing, we've entered the trade from the short side, only to be confronted with a record spike on August 26, courtesy of expectation that Vietnam might be producing less beans. The expected decline is about 20 percent, down to 16 million bags of coffee (a "bag" is about 60 kilos or 132 pounds). Vietnam has become a key producer of the robusta variety of coffee beans, which is a bean that has a bitter flavor character, used for instant coffee, coffee blends with arabica (depending on costs) as the back-up to the more smoother tasting, milder arabica variety. (Uganda is the lead producer in Africa, and also reports via its Coffee Development Authority an anticipated drop in robusta exports.)

On the idea that less robusta means more demand for arabica from coffee processors, futures promptly climbed on the order of 3 cents per pound, a 2.5+ percent spike on August 27. After backing and filling, we took advantage of the higher price and made some profits the following morning as coffee nose-dived and gave back those 3 cents.

At this time, with our contrarian hat on, we also see the possibility for 15 to 20+% move up, from the 1.20+ price level, towards 1.40+. Anything is possible over the longer term, which we all know is guessable but completely unpredictable.

And so what do we do? If we wish to be contrarian and long, we step in very modestly, with stops. But we also suggest to traders not averse to following prices to continue their shorts, and while we do prefer this trade, it is with the understanding we could easily be stopped out by trailing loss (or any risk management regime designed to overcome ego and trades entered with lots of "conviction").

Depending on your risk tolerance for trading this contract, we suggest no less than about a 7.25 cents trailing loss for this 1.20 price area for the Sept 2009 front month, and 7.5 cents for the December 2009 contract. If you choose to ratchet up your stop by moving up to 10+ cents, we wouldn't object, as long as you're one of those deep-pocketed patient traders more tolerant of volatility. (Hopefully you're still averse to risking only up to a maximum of 2 to 4 percent of your equity per trade, but that's your business, if we want excitement we would prefer Vegas.) Anything approaching more than a 10 cent stop, and we've possibly hit prices that make us think, stay out of the shorts, and prepare for a long position.

Those who wish to go long the Vietnam robusta shortage could obviously trade on the Liffee exchange in London, where robusta bounced almost 5 percent, to $1,423 per metric ton on August 26. Stock traders there could trade an ETF from ETF Securities which tracks the DJ-AIG Coffee Sub-Index (COFF.LN). Lastly, a far more abstracted trade could be to short a company whose costs are driven in part by coffee bean prices, and a major customer of arabica beans... you guessed it, Starbucks (SBUX).

Here in the U.S., equity traders may consider iPath DJ AIG Coffee TR Sub-Index ETN (JO), which triggered our sell trend cues around August 21 (no surprise it's so close to the futures cue we observed) but we're not comfortable about liquidity, although ETNs may not have the taxation issues that ETFs do, since there is the mark-to-market issue that futures traders have. With our penchant for stop orders, we suggest about 1.95 - 2.00 per share.

Another worry is how the CFTC could rule regarding position limits of non-hedging futures operations, but more on that in a future piece. If Coffee becomes a "long" trade according to our trend following cues, then, in addition to trading JO, another idea is UBS E-Tracs CMCI Food (FUD), which is a basket of coffee, cocoa and sugar. We've written about trading sugar, and FUD is an equity instrument that could offer exposure to two rising raw materials.

Disclosure: No coffee positions but we are likely to short coffee, but with an eye towards the bitter bean becoming a long trade at some point.