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OPTIONS TRADING STRATEGIES
BUYING COFFEE CALL OPTIONS
Let's say that you have just watched coffee drop sharply to an area of support around 136 cents per pound and believe
that prices will recover at least to challenge recent highs around 148 cents per pound and will probably go even higher.
(See chart at right.) You anticipate this being a good time to get long the market and are considering buying a coffee call
option.
The first step of the
purchase decision
is to determine the maturity of the call option: it must be long enough to capture the anticipated price rally.
Since you suspect that prices will move higher over the next several months,
you decide that the
March 2010 coffee call options that
expire in
mid February
are a good choice. The second step is determining the strike price.
March coffee call options are available across a wide range of strike prices, each having a different cost.
(See table at right.)
Reading Coffee Option Prices
Coffee options are priced
in cents per pound up to two decimals. One coffee option can be exercised into one
coffee "C" futures contract and since each contract is based on 37,500 pounds of coffee, the option price must be
multiplied by 375 to get a corresponding dollar value and every one cent change in the price of the option or the underlying
futures for that matter is worth $375 per contract.
For example, the March coffee call option struck at 1350 (or 135.0 cents per pound) settled at 947 meaning 9.47 cents per pound.
The dollar value of this option is 9.47 x 375 = $3,551.25 This call option is at-the-money
since the March futures contract settled the day at 135.80 cents per pound. Notice that the futures closed
lower over the day by 1.35 cents per pound taking all call option prices lower as well but that the option prices moved by less
than this amount. In fact, this at-the-money call option fell by just 0.75 cents per pound.
As is evident in the table, as the strike price of a call option is raised,
its price declines
as does its sensitivity
to movements in the price of the underlying futures.
Choosing the Strike Price
This requires balancing risk with potential return. The former is simply the cost or purchase price of the option
along with brokerage commission and other trading fees. For example, if you want to risk at most no more than $2,000
on a March coffee call option, then only those options having a strike price of 1475 (or 147.5 cents per pound) or higher would be acceptable.
The potential return is based upon your expectation of how far coffee prices will rally. A useful reference is the
break-even price.
The break-even price of a call option
is calculated by adding the option cost and paid trading fees to the strike price.
Consider, for example, the March coffee call option struck at 1400 (or 140.0 cents per pound). If it is
purchased at the settlement price shown, then the break-even
price of the March futures at option expiration is calculated as:
140.0 + 7.52 + fee value = 147.52 + fee value.
At option expiration, March coffee futures must be above this break-even price in order to
profit on the option trade.
So, you will only consider call options that have a break-even price below the price to which you expect
coffee will rally. Let's say, for example, that you believe March coffee can reach 160.0 cents per pound by option expiration.
Based on this, you would only consider buying call options having a strike price of 1550 (or 155.0 cents per pound) or lower
since otherwise the break-even price is too high.
What remains is the range of acceptable options. In this case, for an investment of at most $2,000 and with an expectation that March
coffee will rally to 160.0 cents per pound by option expiration, the call options having a strike price within the range of 1475 to 1550
would be acceptable to purchase.
After the purchase, you will need to manage the option position.
What if there are no remaining options that are acceptable after considering your desired risk and price expectation? Then you
can consider buying a more expensive call option and manage the risk, or
you can consider buying a bull call spread.
Bull Call Spread
When buying a bull call spread, both strike prices should be below the price to which
you anticipate the futures will rise by the time the options expire, in this case, 160.0 cents per pound. Based on this, there are several spreads
that can be purchased. For example, the 1500/1550 bull call spread has a value of 4.71 - 3.69 = 1.02 = $382.50 plus commission and fees.
If March coffee futures is above 155.0 cents per pound at the time of option expiration, then this spread will close
at its maximum value of $1,875 (calculated as 5 cents x $375 per cent). If coffee is below 150.0 cents per pound,
then this spread will expire worthless.
Stepping down the strike prices will increase marginally the cost of the spread, but the chance of the maximum value
being earned is greater since coffee need not rise so far. For example, the 1450/1500 bull call spread has a value
of 5.96 - 4.71 = 1.25 = $468.75 plus commission and fees. March coffee need only be above 150.0 cents per pound at the time of option expiration
to earn the $1,875 maximum value of the spread. If coffee is below 145.0 cents per pound, then this spread will expire worthless.
As you can see, spreads can be constructed at relatively little expense. You can risk more on a spread in return for greater
potential payout by increasing the gap between the two strike prices. For example, the 1450/1550
bull call spread has a value of 5.96 - 3.69 = 2.27 = $851.25 plus commission and fees but the maximum value is $3,750
and will be earned if March coffee futures is above 155.0 cents per pound at the time of option expiration.
Because the market for option spreads is generally less active than the market for individual options,
you will likely have to pay a slightly higher price in order to effect the purchase. After the purchase,
you will need to manage the option spread position.
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March 2010 Coffee "C" Futures
Settle as of Nov 11, 2009: 135.80 Change: -1.35
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March 2010 Coffee Call Option Prices
Prices as of Nov 11, 2009. Source: The ICE
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