We rarely write about coffee, and we almost never offer up strategy ideas in coffee. Not only are coffee options on the thin side, the risk is generally higher in this market than other commodities due to the explosive nature in pricing, relatively high margins, and the fact that most retail traders don't have real-time quotes on this product due to (in my opinion) unreasonably high data fees charged by the ICE exchange to access live price data. Nevertheless, despite lingering high prices at your favorite coffee shop, we are looking at coffee futures trading at their lowest level in a decade. Further, the Commitments of Traders Report issued by the CFTC (Commodity Futures Trading Commission) suggests the number of short traders in this market is at a historical high.
In short, it feels like coffee prices are over-extended to the downside and are due for a massive bounce. Although we believe this is the most likely scenario regardless of action in the currency markets, a reversal in the greenback, which appears to be in the cards, could propel commodity buying which could trigger a surprisingly swift recovery in coffee futures.
This premise is corroborated by technical oscillators. The RSI (Relative Strength Index) is trading well below 30, which in the past has been a precursor for substantial rallies in coffee. Additionally, the William's %R indicator is hovering near zero; this indicator is quicker and less reliable than the RSI but a reading near zero is usually good for a temporary bounce.
We thought long and hard about how a trader could play the upside in coffee given the aforementioned difficulties involved in trading this particular market. In the end, we believe experienced traders (not those who are new to options or green as a commodity trader) are likely best off constructing a bull call spread with a naked short put. The put we like selling has gained value exponentially in recent days, so it could lose value quickly if prices stabilize and that will help to finance the primary component of the trade; a vertical call spread.
To clarify, the easiest way to explain the strategy is it is a bull call spread (bullish vertical call spread) that is paid for via the sale of a naked put option. In this particular case, we wouldn't be comfortable with unlimited risk on the downside so traders should look to purchase a cheap coffee put in a closer expiration month to act as catastrophic insurance out of the gate.
To give you an idea of what this might look like: A trader might consider buying the December coffee $110 call, then selling the December $120 call, and then selling the December $95 put to pay for the call spread (this portion of the trade has about three months to expiration). A viable insurance policy might be the October $92.50 (which expires in less than a month). After all is said and done, this trade should be close to "free"; this means the cash collected on the short legs of the spread should pay for the cost of the long spreads (this is a ballpark assumption, fills might be a little better or worse...and don't forget transaction costs).
The risk on this version of the trade is difficult to quantify because the insurance expires prior to our primary position but we suspect if the market falls sharply against us the loss should be around $1,000 to $1,500 (but far less in most scenarios). If held to expiration, the maximum payout on this trade is roughly $3,750 prior to transaction costs. If the market runs sharply in favor of the trade in the short run, we recommend taking a quick profit. If in this market, if you receive a gift it is best not to ask questions or get greedy.
*THERE IS A SUBSTANTIAL RISK OF FINANCIAL LOSS IN TRADING FUTURES AND OPTIONS.
(Carley Garner's article originally appeared on Real Money Pro at 10:00 a.m. ET on Aug. 21. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)