The Trend Is Your Friend In Supply-Burdened Coffee Market

Includes: JO
by: James Cordier

With the 2018 Brazilian Harvest Wrapping up, a likely record coffee crop will be flooding the world market in the coming months.

The market has been anticipating this supply influx for some time, which is why the coffee market has been in a steady downtrend for nearly 6 months.

You may think, as an option seller, that you should only be selling options in markets that are at extreme highs or lows at levels above or below those highs or lows.

Nothing could be further from the truth.

If you're considering branching out into the diversified commodities markets, especially as an option seller, you don't want to avoid quietly trending markets. This type of price action typically indicates markets with steady, discernable, longer-term fundamentals. These types of fundamentals are unlikely to change dramatically over 3-6 months.

"The world's biggest supplier of coffee finishes up a record harvest this month."

While corrections are normal in any trending market, "the trend is your friend" is a generally accurate and lucrative axiom to an option seller.

This month, we present just such a potential opportunity in thecoffee market.

Brazil: Coffee King

Understanding the coffee growing cycle is the key to selecting when and where to sell options in this commodity. And understanding coffee often means starting with Brazil.

Brazil is by far the world's largest producer and exporter of coffee - in particular, the higher quality Arabica coffee used to satisfy the majority of the ICE Coffee futures contract. Thus, developments in the Brazilian crop are key to forecasting coffee prices.

Brazil is the world's largest producer and exporter of coffee beans.

The Harvest Seasonal

While past performance is not necessarily indicative of future results,seasonal tendencies can be powerful tools in commodity price analysis. Coffee is no exception.

With theBrazilian harvest typically wrapping up by September, the market must brace for an onslaught of new supplies flooding the world markets. As supply is typically highest in the time immediately after harvest, coffee prices have historically tended to hit their lowest points of the year in the months following it. That means November, December and even January. The seasonal chart below illustrates this tendency.

Coffee prices tend to hit seasonal lows in the months following conclusion of the Brazilian harvest in September. That doesn't mean it can't rally. Flowering season for next year's crop occurs in October. As stated earlier, poor weather during this time period can occasionally bring buying into the market.

Much also depends on how much supply is coming out of Brazilian growing regions. Which brings us to perhaps the bigger point.

2018 Fundamentals - An All-Time Record Harvest

By most accounts, the 2018/19 Brazilian crop is expected to be an all time record at or above 60 million bags of coffee.

2018/19 Brazilian Coffee Production Will Hit an All-Time Record High

This much supply hitting the market will be a bearish force for prices for months to come.

Conclusion and Strategy

The world's biggest supplier of coffee finishes up a record harvest this month. This brings 60 million bags of new supply to the global market. While the trade has been pricing this crop for much of the year, its arrival is no bellwether for prices. In our opinion, the excess supply will be a cement block on the ankle of prices in the months ahead.

"Trends are excellent markets in which to sell options, often enabling you to milk premium for months or even years off of a few persistent fundamentals."

Further hindering bulls is a powerful seasonal tendency for prices to fall further into year's end.

All of this being the case, we advise patience in positioning in this market.Trends are excellent markets in which to sell options, often enabling you to milk premium for months or even years off of a few persistent fundamentals. And while we view coffee as such a market, it is due for a corrective rally.

October flowering could provide an excuse for one. Waiting for such a rally may enable you to sell higher strikes forlarger premiums.

Our managed portfolios have been writing coffee calls for much of 2018, and we expect it to continue to be a core strategy for the remainder of 2018. We would view technical rallies as opportunities for taking additional premium.

March 2019 Coffee

Selling the March 1.60 Coffee Call Options

Self-directed traders can consider selling theMarch 1.60 call on limited rallies this month. Target premiums of $400-$500+ per option. 1.80 or even 2.00 strikes could become viable with a more substantial bounce.

It would likely take an unforeseen and severe weather event to push coffee prices anywhere near 1.60 per pound. With the end of Brazilian winter approaching, the chances of such an event decrease daily. Risk of loss, of course, is always present in any trade and thus, risk parameters should continue to be minded.

Nonetheless, current margin requirement to premium ratio projects a43% return per option should the options expire worthless. That's getting paid pretty well to bet against the improbable.