Buying Coffee Put Options to Profit from a Fall in Coffee Prices

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Contents

Buying Coffee Put Options to Profit from a Fall in Coffee Prices

If you are bearish on coffee, you can profit from a fall in coffee price by buying (going long) coffee put options.

Example: Long Coffee Put Option

You observed that the near-month Euronext Robusta Coffee (No. 409) futures contract is trading at the price of USD 1,648 per tonne. A Euronext Coffee put option with the same expiration month and a nearby strike price of USD 1,600 is being priced at USD 109.87/ton. Since each underlying Euronext Robusta Coffee (No. 409) futures contract represents 10 tonnes of coffee, the premium you need to pay to own the put option is USD 1,099.

Assuming that by option expiration day, the price of the underlying coffee futures has fallen by 15% and is now trading at USD 1,401 per tonne. At this price, your put option is now in the money.

Gain from Put Option Exercise

By exercising your put option now, you get to assume a short position in the underlying coffee futures at the strike price of USD 1,600. In other words, it also means that you get to sell 10 tonnes of coffee at USD 1,600/ton on delivery day.

To take profit, you enter an offsetting long futures position in one contract of the underlying coffee futures at the market price of USD 1,401 per tonne, resulting in a gain of USD 199.00/ton. Since each Euronext Robusta Coffee (No. 409) put option covers 10 tonnes of coffee, gain from the long put position is USD 1,990. Deducting the initial premium of USD 1,099 you paid to purchase the put option, your net profit from the long put strategy will come to USD 891.30.

Long Coffee Put Option Strategy
Gain from Option Exercise = (Option Strike Price – Market Price of Underlying Futures) x Contract Size
= (USD 1,600/ton – USD 1,401/ton) x 10 ton
= USD 1,990
Investment = Initial Premium Paid
= USD 1,099
Net Profit = Gain from Option Exercise – Investment
= USD 1,990 – USD 1,099
= USD 891.30
Return on Investment = 81%

Sell-to-Close Put Option

In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the coffee option sale will be equal to it’s intrinsic value.

Learn More About Coffee Futures & Options Trading

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Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Coffee Options Explained

Coffee options are option contracts in which the underlying asset is a coffee futures contract.

The holder of a coffee option possesses the right (but not the obligation) to assume a long position (in the case of a call option) or a short position (in the case of a put option) in the underlying coffee futures at the strike price.

This right will cease to exist when the option expire after market close on expiration date.

Coffee Option Exchanges

Coffee option contracts are available for trading at NYSE Euronext (Euronext).

Euronext Coffee option prices are quoted in dollars per metric ton and their underlying futures are traded in lots of 10 tonnes of coffee.

Exchange & Product Name Underlying Contract Size Exercise Style Option Price Quotes
Euronext Coffee Options 10 ton
(Full Contract Specs)
American Calls | Puts

Call and Put Options

Options are divided into two classes – calls and puts. Coffee call options are purchased by traders who are bullish about coffee prices. Traders who believe that coffee prices will fall can buy coffee put options instead.

Buying calls or puts is not the only way to trade options. Option selling is a popular strategy used by many professional option traders. More complex option trading strategies, also known as spreads, can also be constructed by simultaneously buying and selling options.

Coffee Options vs. Coffee Futures

Additional Leverage

Limit Potential Losses

As coffee options only grant the right but not the obligation to assume the underlying coffee futures position, potential losses are limited to only the premium paid to purchase the option.

Flexibility

Using options alone, or in combination with futures, a wide range of strategies can be implemented to cater to specific risk profile, investment time horizon, cost consideration and outlook on underlying volatility.

Time Decay

Options have a limited lifespan and are subjected to the effects of time decay. The value of a coffee option, specifically the time value, gets eroded away as time passes. However, since trading is a zero sum game, time decay can be turned into an ally if one choose to be a seller of options instead of buying them.

Learn More About Coffee Futures & Options Trading

You May Also Like

Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Prices Plunging? Buy a Put!

Investors may buy put options when they are concerned that the stock market will fall. That’s because a put—which grants the right to sell an underlying asset at a fixed price through a predetermined time frame—will typically increase in value when the price of its underlying asset heads southward. Therefore, if you own a put you will benefit from a down marketeither as a short speculator or as an investor hedging losses against a long position.

So, whether you own a portfolio of stocks, or you simply want to bet that the market will go down, you can benefit from buying a put option.

Key Takeaways

  • A put option gives the owner the right, but not the obligation, to sell the underlying asset at a specific price through a specific expiration date.
  • A protective put is used to hedge an existing position while a long put is used to speculate on a move lower in prices.
  • The price of a long put will vary depending on the price of the stock, the volatility of the stock, and the time left to expiration.
  • Long puts can be closed out by selling or by exercising the contract, but it rarely makes sense to exercise a contract that has time value remaining.

Prices Plunging? Buy A Put!

Speculative Long Puts vs. Protective Puts

If an investor is buying a put option to speculate on a move lower in the underlying asset, the investor is bearish and wants prices to fall. On the other hand, the protective put is used to hedge an existing stock or a portfolio. When establishing a protective put, the investor wants prices to move higher, but is buying puts as a form of insurance should stocks fall instead. If the market falls, the puts increase in value and offset losses from the portfolio.

Opening a long put position involves “buying to open” a put position. Brokers use this terminology because when buying puts, the investor is either buying to open a position or to close a (short put) position. Opening a position is self-explanatory, and closing a position simply means buying back puts that you had sold to open earlier.

Practical Considerations

Besides buying puts, another common strategy used to profit from falling share prices is to sell stock short. Short sellers borrow the shares from their broker and then sell the shares. If the price falls, the stock is bought back at the lower price and returned to the broker. The profit equals the sale price minus the purchase price.

In some cases, an investor can buy puts on stocks that cannot be found for short sales. Some stocks on the New York Stock Exchange (NYSE) or Nasdaq cannot be shorted because the broker does not have enough shares to lend to people who would like to short them.

Importantly, not all stocks have listed options and so some stocks that are not available for shorting might not have puts either. In some cases, however, puts are useful because you can profit from the downside of a “non-shortable” stock. In addition, puts are inherently less risky than shorting a stock because the most you can lose is the premium you paid for the put, whereas the short seller is exposed to considerable risk as the stock moves higher.

Like all options, put options have premiums whose value will increase with greater volatility. Therefore, buying a put in a choppy or fearful market can be quite expensivethe cost of the downside protection may be higher than is worthwhile. Be sure to consider your costs and benefits before engaging in any trading strategy.

An Example: Puts at Work

Let’s consider stock ABC, which trades for $100 per share. Its one-month puts, which have a $95 strike price, trade for $3. An investor who thinks that the price of ABC shares are too high and due fall within the next month can buy the puts for $3. In such a case, the investor pays $300 ($3 option quote x 100, which is known as the multiplier and represents how many shares one option contract controls) for the put.

The breakeven point of a $95-strike long put (bought for $3) at expiration is $92 per share ($95 strike price minus the $3 premium). At that price, the stock can be bought in the market at $92 and sold through the exercise of the put at $95, for a profit of $3. The $3 covers the cost of the put and the trade is a wash.

Profits grow at prices below $92. If the stock falls to $80, for example, the profit is $12 ($95 strike – $80 per share – the $3 premium paid for the put = $12). The maximum loss of $3 per contract occurs at prices of $95 or higher because, at that point, the put expires worthless.

The distinction between a put and a call payoffs is important to remember. When dealing with long call options, profits are limitless because a stock can go up in value forever (in theory). However, a payoff for a put is not the same because a stock can only lose 100% of its value. In the case of ABC, the maximum value that the put could reach is $95 because a put at a strike price of $95 would reach its profit peak when ABC shares are worth $0.

Close vs. Exercise

Closing out a long put position on stock involves either selling the put (sell to close) or exercising it. Let us assume that you are long the ABC puts from the previous example, and the current price on the stock is $90, so the puts now trade at $5. In this case, you can sell the puts for a profit of $200 ($500-$300).

Options on stocks can be exercised any time prior to expiration, but some contracts—like many index options—can only be exercised at expiration.

If you wished to exercise the put, you would go to the market and buy shares at $90. You would then sell (or put) the shares for $95 because you have a contract that gives you that right to do so. As before, the profit, in this case, is also $200.

The value of a put option in the market will vary depending on, not just the stock price, but how much time is remaining until expiration. This is known as the option’s time value. For example, if the stock is at $90 and the ABC $95-strike put trades $5.50, it has $5 of intrinsic value and 50 cents of time value. In this case, it is better to sell the put rather than exercise it because the additional 50 cents in time value is lost if the contract is closed through exercise.

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