Contract Specifications and Economics

Free Coffee Futures Trading eGuide

Coffee Futures: Coffee’s beginnings are lost in antiquity, but it is believed to have originated in the Ethiopian province of Kaffa around 3 A.D. where ground beans were used to season food. In about 1300 A.D. the southern Arabians first roasted and brewed coffee for use as a beverage. Today, coffee is one of the world’s most popular drinks and is among the world’s most important internationally traded commodities, with a number of economics largely dependent in its trade.

Located at ICE Futures U.S. in New York City, ICE is the premier world market for the trading of coffee, sugar and cocoa futures and options, and since 2007, an innovator in the trading of futures and options in dairy products.

Coffee Futures Economics

Coffee Supply

Coffee trees, or bushes, grow primarily in subtropical climates. Coffee beans are the seeds of cherry-sized berries, the fruit of the coffee tree. Coffee is primarily classified in two types — arabica and robusta. Arabian coffees, which make up the bulk of world production, are grown mainly in the tropical highlands of the Western Hemisphere. Robusta coffees are produced largely in the low, hot areas of Africa and Asia. Their flavors are less mild than the arabica coffees.

South and Central America produce the majority of coffee trade in world commerce. Brazil and Colombia, the largest growers of arabica coffees, accounted for about 41% of world green coffee production on average for the past five crop years from 1991/92 through 1995/96.

Coffee beans are shipped and warehoused in natural fiber bags, and coffee sales are usually accomplished through the use of inspected samples offered by importers and brokers.

The supply of coffee is affected by weather conditions, the health of the coffee trees, and harvesting practices. Historically, weather has played a major role in determining world supply. For example, production increases after recovery from the 1953 Brazilian frost induced big price declines; likewise, a Brazilian frost in1975 and drought in 1985 caused a sharp drop in coffee production and similarly dramatic increases in coffee prices.

The internal policies of the governments of producing countries with regard to number of trees planted, price support programs and world export quotas have also impacted the amount of coffee available for world trade. For instance, the collapse of an international agreement among the majority of coffee producers and consumers in the summer of 1989 was followed by a price decrease from $1.30/pound to $.98/pound in under a month.

Coffee Futures Demand

Coffee demand is primarily determined by its price, the price and availability of substitute drinks and consumer’s tastes. In periods of normal price variations, the demand for coffee is price inelastic. This means that when coffee prices rise, people do not reduce their coffee consumption proportionally, and when coffee prices fall, consumer demand for coffee does not proportionally increase to any great extent. However, when coffee prices show big increases, consumers tend to reduce their consumption commensurately. Thus, the sharp rise in coffee prices in 1976 and 1977 met with a large reduction in coffee consumption.

In the United States, over the last 30 years, per capita coffee consumption has declined considerably and limited population growth has led total consumption to even out over the past decade. Although high coffee prices were primarily responsible for the 1976-77 cutback in per capita coffee consumption, some studies attribute the longer-term decline mostly to changing tastes and very little to price changes. There is some evidence to suggest that changing American lifestyles have enabled soft drinks to compete with coffee as a social drink.

The downward trend in the United States’ per capita consumption of coffee has been more than made up for by rising European demand. While the United States coffee imports have dropped from 2/3 of total world coffee imports in the late 1940s to 1/4 of total world imports in recent years, Europe’s coffee imports have risen sharply. Therefore, consumption trends in Europe will be at least as important to the analysis of future demands for coffee as like trends in the United States.

Coffee Futures The Role of the Exchange

ICE Futures U.S. is the world’s premier forum for coffee futures and options trading.

As an exchange, ICE Futures U.S. does not participate in coffee price determination. Rather, it provides a visible, free-market setting where members can conduct futures and options transactions subject to Exchange rules and regulations. Since all futures and options contracts are standardized (with delivery months and locations, quantity and grade constant), only price is negotiable. The exchange environment allows prices to reach their natural levels — an important economic function known as price discovery.

Those prices are determined by open outcry trading on the Exchange floor. The open outcry method employs actual vocal bidding and assures that each trade is openly and competitively executed. With open outcry, all market participants are afforded the opportunity to buy or sell at the best available current price. The Exchange rapidly disseminates transaction prices all over the world.

Market participants are comprised of two main groups: hedgers and investors. Hedgers are primarily commercial firms that trade futures and options to reduce their risk to unfavorable price movements in the physical markets. Hedging with futures allows firms to lock in prices for future purchases or sales assisting in business planning and smoothing operations. Options hedging provides the ability to manage risk in many different market environments by paying premiums for price protection or earning income through option sales to augment marketing opportunities. Traditionally, hedgers have included coffee producers, importers and roasters.

Investors are individuals seeking profits from changing prices. Investors typically place orders through brokerage firms (known as futures commission merchants or FCMs), or firms known as introducing brokers (IB’s) that have relationships with FCMs. Individuals also are increasingly investing in futures through commodity funds managed by commodity trading advisors (CTAs). CTAs manage portfolios of futures contracts similar to the way investment advisors manage portfolios of securities in mutual funds.

All FCMs and CTAs must be registered with the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) in order to handle customer funds. The CFTC is the federal regulatory agency responsible for the oversight of all futures markets. The NFA is a self-regulatory organization registered with the CFTC charged with enforcing ethical standards and customer protection rules as well as screening futures professionals for membership.

Hedgers and investors are joined in the market by floor traders — independent, professional traders who trade for their own accounts. Floor traders add liquidity to the market, increasing efficiency and facilitating commercial hedging and individual investment objectives.

While transactions occur on the trading floor, financial settlement is performed by the Commodity Futures Clearing Corporation of New York (CFCCNY), a membership organization which clears all transactions executed on the Exchange floor. Each day, the details of every trade are submitted to the CFCCNY by its members and matched. The Clearing Corporation then assures the opposite side of clearing member’s positions — becoming the buyer to every seller and seller to every buyer. Ultimately, the CFCCNY assures contract performance through stringent financial requirements and clearing member position limits.

All trading activity is closely monitored by the Exchange according to guidelines established by the CFTC. The Exchange is committed to maintaining markets of the highest integrity. Toward fulfilling this self-regulatory mandate, the CSCE employs advanced technological systems to perform a variety of surveillance and compliance procedures.

Coffee Futures

A futures contract is a standardized, binding agreement to make or take delivery of a specified quantity and grade of a commodity at an established point in the future at an agreed upon price. A contract buyer is obligated to take delivery of coffee according to contract terms at a specified date, while sellers are obligated to make delivery. Buyers are considered to be long and sellers short the futures contract.

The vast majority of futures contracts never result in actual making or taking delivery. Instead, contract holders liquidate their positions by executing offsetting transactions in the market. Longs sell the contracts they bought and shorts buy their contracts back, removing delivery obligations.

Coffee Futures Margin

Toward ensuring contract performance, the Exchange requires that market participants make original and variation margin payments. Original margins are good faith deposits established to ensure that market participants will meet their contractual financial obligations. Original margins are established by the Exchange, and are periodically adjusted to reflect changing market conditions, especially price volatility. At the close of each trading day, margin accounts are marked to the market; that is, they are adjusted to reflect price movements in the futures market each and every trading day. When prices move unfavorably to a trader’s position, additional or variation margin payments are required to restore margin to original levels.

Coffee Futures Leverage

A major attraction of futures trading for investors is leverage. Since futures transactions do not require full advance payments for the commodity (just the margin), the buyer of a futures contract which increases in value (or the seller of futures contract which decreases in value) can realize a profit which can be substantial in relation to the commitment of capital. Assume that an investor can purchase coffee futures contracts (each representing 37,500 pounds of coffee) with a $3,000 margin deposit. Thus, if the investor bought one contract at 150.00 cents/pound ($56,250 worth of coffee) and sold the contract when coffee reached 165.00 cents/pound, he would realize a profit of $5,625 (15.00 cents x 37,500 pounds = $5,625) — a 187.5% return on the initial margin deposit, which is returned when the position is liquidated.

That’s leverage, and it can be a powerful investment tool. Of course, leverage works both ways. If futures prices were to move opposite from the anticipated direction, an investor could lose the entire margin deposit and more.

Coffee Futures Options

With its launch of options on world sugar futures in 1982, the CSCE became the first Exchange to trade options on commodity futures. In 1986, options on coffee futures commenced trading. Because option strategies are numerous and can be tailored to meet a wide array of risk profiles, time horizons and cost considerations, hedgers and investors alike are increasingly realizing their vast potential. As a result, coffee options volume has grown considerably.

Coffee Options Buyers

Option buyers obtain the right, but not the obligation to enter the underlying futures market at a pre-determined price within a specified period of time. A call option confers the right to buy (go long) futures, while a put option confers the right to sell (go short) futures. The pre-determined price is known as the strike or exercise price, the last day when an option may be exercised is the expiration date. Buyers pay sellers a premium for their option rights.

Because an option holder is under no obligation to enter the futures market, losses are strictly limited to the purchase value: there are no margin calls. If the underlying futures market moves against an option position, the holder can simply let the option expire worthless. On the opposite side, potential gains are unlimited, net of the premium cost. That feature allows hedgers to guard against adverse price movements at a known cost without foregoing the benefits of favorable price movements. In an options hedge, gains are only reduced by the premium paid — unlike futures hedge, where gains in the cash market are offset by futures market losses.

Option holders can exit their position in one of three ways: exercising the option and entering the futures market; selling the option back in the market; or simply letting the option expire worthless.

Coffee Options Sellers

Option sellers, or writers, receive a premium for granting option rights to buyers. In exchange for the premium, writers assume the risk of being assigned a position opposite that of the buyer in the underlying futures market at any time prior to expiration. Writers of call options must be prepared to assume short positions at the option’s strike price at the option holder’s discretion, while put option writers may be assigned long futures positions.

Writing put and call options can serve as a source of additional income during relatively flat market periods. Because option writers must be prepared to enter the futures market at any time upon exercise, they are required to maintain a margin account similar to that for futures. Sellers can offset their positions by buying back their option in the market.

Coffee Options Strike Price

Traders agree on premiums in an open outcry auction similar to that for futures contracts. The Exchange generally lists thirteen strike prices for each option month: one at or near the futures price, six above and six below. As futures prices rise or fall, higher or lower strike prices are introduced according to a present formula.

Coffee Option Premiums

A number of factors impact premium levels in the market. Chief among them is an option’s intrinsic value. Intrinsic value is the dollars and cents difference between the option strike price and the current futures price. An option with intrinsic value has a strike price making it profitable to exercise and is said to be in-the-money (strikes below futures price for calls, above for puts). An option not profitable to exercise is out-of-the-money (strikes above futures prices for calls, below for puts). At-the-money options have strike prices at or very near futures prices. In general, an option’s premium is at least equal to its intrinsic value (the amount by which it is in-the-money).

Time value is the sum of money buyers are willing to pay for an option over and above any intrinsic value the option may presently have. Time value reflects a buyers’ anticipation that, at some point prior to expiration, a change in the futures price will result in an increase in the option’s value. The premium for an out-of-the-money option is entirely a reflection of its time value.

Premiums are also affected by volatility in the underlying futures market. Because high levels of volatility increase the probability that an option will become valuable to exercise, sellers command larger premiums when markets are more volatile. Finally, premiums are affected by supply and demand forces and interest rates relative to alternative investments.

Coffee Option Months

Coffee options are traded on futures contracts having March, May, July, September and December delivery periods. The option month refers to the futures contract delivery month rather than the month in which the option actually expires.

In general, the last trading day for coffee options is the first Friday of the month preceding the futures contract delivery month.

Example: Buying a Call

Buying a call can be employed to profit from, or achieve protection against, an increase in the price of coffee. Except for the cost of the option, the profit potential is similar to having a long position in the underlying futures contract. Moreover, this strategy may provide greater staying power in the event of a temporary price setback than having an outright long futures position. Reason: there are no margin calls because you cannot lose more than the premium paid for the option, plus commission and fees.

For example, assume in July an investor foresees higher coffee prices by winter’s onset. With December futures trading at 150.00 cents/pound, the investor decides to purchase a December 150 call (an at-the-money option) for 5.25 cents/pound. Since each contract represents 37,500 pounds of coffee, the total premium paid is $1,968.75.

The maximum loss the investor can incur is the premium paid, regardless of how far futures prices fall. However, potential profit is unlimited since the option holder gains dollar-for-dollar in the rise of the underlying futures price minus the cost of the premium.

Call options can be purchased for price protection as well as for the pursuit of trading profits. Commercial firms buying call options effectively establish a maximum purchase cost equal to the exercise price of the option plus the option premium. Employed in this way, options offer hedgers price insurance, while at the same time allowing them to benefit from price declines since they can allow the option price to expire unexercised.

Example: Buying a Put

Whereas buyers of calls can profit from rising prices, buyers of put options — rights to sell futures contracts at the option exercise price — can profit from a price decline. Except for this difference, the properties of puts and calls are the same.

To realize a profit expiration, the underlying futures price must be below the option exercise price by an amount greater than the premium paid for the option. If it is higher, a portion or all of the premium will be lost. In no case, can losses exceed the premium paid.

For example, the investor in February expecting depressed coffee prices during the summer can purchase July puts. With July futures trading at 156.00 cents/pound, the investor purchases a July 155 put for 15.00 cents/pound (15.00 cents x 37,500 pounds = $5,625.00/contract)

The investor can lose no more than the premium paid, no matter how high futures prices climb. On the other hand, if prices decline, the investor can realize substantial gains. A futures sale at the strike price would have similar profit opportunities in a falling market — plus the premium paid to obtain the option. However, losses from a short futures position would be unlimited in a rising market.

Commercial firms can purchase put options against inventory as insurance against price decreases. The firm may choose the cost or deductible for the insurance by selecting either in-the-money, at-the-money or out-of-the-money puts. For example, say a July 155 put would cost 7.70 cents/pound and a 165 put 12.10 cents/pound in April when futures were trading at 164.50 cents/pound. The 155 put would provide 10.00 cents/pound less protection than the 165 put, but could be obtained at a lower cost.

Coffee Futures Contract

Calls for delivery of washed arabica coffee produced in several Central and South American, Asian, and African countries, or unwashed arabica coffee of Ethiopia.

Trading Units: 37,500lbs. (approximately 250 bags)

Trading Hours: 4:15A.M. to 1:30P.M. New York Time

Price Quotation: Cents per pound

Delivery Months: March, May, July, September, December

Ticker Symbol: KC

Minimum Fluctuation: 5/100 cent/pound, equivalent to $18.75 per contract.

Daily Price Limits (from previous day’s settlement price): 6.00 cents with variable limits effective under certain conditions. No price limits on two nearby months.

Coffee Options Contract

Confers to buyer the right to buy (in the case of a call) or sell (in the case of a put) one coffee C futures contract.

Trading Unit: One coffee C futures contract

Trading Hours: 4:15A.M. New York Time until the completion of the closing period which shall commence at 1:30P.M.

Price Quotation: Cents per pound

Contract Months: Regular Options: March, May, July, September, December; Serial Options: January, February, April, June, August, October, November

Ticker Symbol: KC

Minimum Fluctuation: 1/100 cent/pound, equivalent to $3.75 per contract.

Daily Price Limits: None