Trade Idea So Good You Can Taste it

09/16/2011 9:00 am EST

Focus: COMMODITIES

Andy Waldock

Founder, Commodity & Derivative Advisors

Coffee prices are at historically high levels and may be due for a sizable correction, offering a potentially lucrative short play for willing futures traders.

This week, I’d like to get away from the pending doom and gloom in Europe and share a little good news on something a little closer to all of our hearts: the morning cup of coffee. We discussed the prospects for higher coffee prices throughout 2011 nearly a year ago due to increasing end-line demand and a change in the way the exchange accepted coffee for delivery.

Most major roasters raised prices by 10%-15% throughout 2011. The fact that they were able to keep prices reasonable in the face of a coffee supply price that nearly doubled was a testament to the effectiveness of forward hedging in the futures markets. Fortunately, coffee prices may have just seen their peak.

Coffee prices traded at over $3 per pound earlier this year. These historically high levels have only been seen twice before this year, and those were 20 years apart, in 1977 and 1997.

Here’s a daily chart of the December 2011 futures contract:

chart
Click to Enlarge

In May, coffee futures reached $3.08 per pound. I believe this will mark the high point for this rally. Last December, we projected a high of perhaps $2.70 per pound based on the supply and demand factors in the market. The rally to the highs has been the work of commercial coffee growers who oversold their forward production.

The futures markets allow farmers to lock in market prices for crops that they intend to deliver at the end of the growing season. Depending on the farmer, they may borrow money to sell forward production using margin. Their loans are procured using their crops as collateral.

Typically, both producers and processors have a good idea of the value area for their given markets. Therefore, this strategy allows both the producers and the processors to more efficiently run their businesses. However, there are times when the market moves beyond its expected boundaries and commercial margin traders find themselves overleveraged. This is what pushed the market above $3 per pound.

The commercial traders’ actions are reported weekly in the Commitment of Traders Report, and we can clearly see that the only group actively buying coffee futures at these prices are commercial producers who oversold their forward production and are trying to manage their losses as best they can.

See video: Using the Commitment of Traders Report

What can we expect going forward? Using history as an analog, we know that the previous two ventures above $3 per pound saw the coffee market return to its baseline levels from the beginning of the rally. In other words, it gives back all of its gains. In this case, a reasonable target would be the $1.60 area, where it was trading last July.

Coffee is currently trading around $2.70 per pound. Given the size of the coffee contract of 37,500 pounds, this equals a dollars and cents risk of approximately $14,250 with a potential reward of $41,250.

As you can see, coffee is one of the more volatile contracts to trade and we will be looking for selling opportunities going forward.

By Andy Waldock of Commodity & Derivative Advisors

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