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

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Put Options Trading – Buying Puts for Beginners

Put options are a bear’s best friend. Here’s why.

Bear markets and price corrections have plagued stock prices since the dawn of our modern marketplace. While it would be delightful to ban the volatility beast once and for all from Wall Street, such a fantasy only exists in the profit-filled dreams of perma-bulls.

Fortunately, educated investors have a number of weapons at their disposal to not only survive the occasional volatility attacks, but profit from them. Indeed, some skilled traders look forward to bear markets with downright giddiness as that’s when their bearish strategies really score.

Chief among these traders’ profit generating tactics is buying put options.

Perhaps you’ve heard of the puts bullish counterpart, the call option. While call options give you the right to buy stock, put options give you the right to sell stock. Here’s the full definition:

A put option gives the buyer of the contract the right, but not the obligation, to sell 100 shares of stock at a specific price on or before an expiration date.

This right to sell a stock at a set price becomes increasingly valuable as the stock price falls further and further. Let’s say Apple Inc. (NASDAQ:AAPL) is perched at $150 and I buy a three-month put option giving me the right to sell 100 shares of AAPL at $150. If AAPL stock were to fall to $130, then having the right to sell the stock back up at $100 would become quite attractive.

This is why buying put options is touted as a bearish trade and can produce big profits when stocks tank.

When you really begin to dig into the world of buying puts, you’ll discover they are quite the alluring alternative to shorting stock. Buying a put is a heck of a lot cheaper and offers a fair bit more leverage. Plus, you don’t have to borrow shares of stock to initiate your position.

The first step to buying put options is identifying a stock you believe will fall in value. Then, determine how long you plan on being in the position. Because options have an expiration date you have to choose how much time to buy.

Let’s say I think Wal-Mart Stores Inc (NYSE:WMT) is going to drop over the next two months. Rather than simply buying a two-month put option, try grabbing an extra month or two for good measure. It’s always better to have too much time rather than too little. Plus, you will limit the effect of time decay by using longer-term options.

The next choice involves selecting which strike price to buy. Buying in-the-money put options is more conservative so consider starting there. In-the-money puts are those with a strike price above the stock price. With WMT sitting at $75 we could buy a three-month $77.50 put for $3.20. Since put prices are listed on a per share basis, the $77.50 put would cost a grand total of $320, or $3.20 times 100. The initial cost also represents the max risk in the position.

The reward for buying put options is limited only by the stock falling to zero. Just like a stock trade, the objective of our put option play is to buy low and sell high. A big enough drop in WMT stock could send our $3.20 put option to $5, $6, $7 or even higher.

Once the stock has made the forecast drop, exit gracefully with profits in tow. Simple as that.

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How to profit off a stock price falling

How would one profit from a share price falling, granted that they correctly predicted it would happen?

Say I had a hunch that a certain stock was going to fall next week, how could I effectively make a profit on this.

4 Answers 4

The three normal ways profit on falling stock prices are:

  1. Short sale: Borrow someone else’s shares. Sell at current price. Wait for price to fall. Buy back at lower price. Return shares to owner.
  2. Buy put options with a strike price lower than current price. When stock drops below strike price of put, either buy shares at new low price and exercise the option to sell at a high price, or sell the option.
  3. Sell/write call options with strike price above current share price. As share price goes down no one exercises the call options. When they expire, keep the money made from selling them.

However, all three of the above are extremely dangerous for a novice investor and are not recommended to anyone without significant experience and understanding of derivatives, as well as the willingness to risk unlimited amounts of money.

1 & 3 will allow you to lose everything if the prices go up instead. With option 2 the most you lose is what you spent on buying the put options.

You can short sell shares, buy put options or write call options as noted above, but make sure you have stop loss orders in place if you are going long or short.

Another method you could use to also profit from a falling market is to buy bear ETFs (Exchange Traded Funds), you can use these to trade the market as a whole or to profit from falling sectors or whatever else might be covered by bear ETFs.

And if you are not in the US, you can trade CFDs (Contracts For Difference), which you can go both long and short in. But again remember to not overtrade (as CFDs use margin) and to use stop losses appropriately.

You can profit from a share price falling by what is known as shorting the stock. Effectively you borrow the stock from a broker willing to loan it to you at the current price then ‘sell’ it back to them when the price of the stock falls. The difference is yours to keep.

Be warned however this is a risky position to take as it now exposes you to theoretically infinite losses if the stock moves the other way. When you’re ‘long’ a stock, you can only lose the money you spent on it.

Ways to benefit if a security is dropping:

1) Short the shares if they are borrowable and the borrow fee isn’t huge. This requires a margin account. Borrow fees can be as low as 0.25 pct or crazy numbers like 50-75-100% per year. Buy them back for a profit if price drops. Buy them back for a loss if they rise.

2) Buy put options. To capture smaller moves, buy ITM puts. They will lose more than OTM puts if you are wrong. For leverage, buy OTM puts. If you get a big move, the ROI is higher than with ITM puts. If wrong, you will lose less (on a 1:1 basis). The delta of the option will tell you how much the option should gain (or lose) per point of stock movement. Delta is non linear and affected by the level of implied volatility so keep in mind that it’s an approximation.

3) Sell/write covered calls. If they expire, you keep the money made from selling them. This is more of an income proposition and unless the calls are deep ITM, they will hedge the underlying poorly (small premium against large underlying drop). And as the stock drops, you may find yourself in a position where there is no strike price that you can write without locking in a loss.

(1) (short stock) is the only dangerous choice.

(2) (long puts) has limited risk.

(3) is an opportunity risk if the price rises and you are assigned and must sell the stock at the strike price (you don’t participate in the upside).

If you want a global approach, you can buy inverse ETFs but they bear a similar risk to shorting.

Shorting is risky and should only be don by those who are experienced and who practice good risk management. While it is true that there are “theoretically infinite losses if the stock moves the other way”, that’s just not reality. No stock has ever gone to infinity and no big cap stock will ever do this. You manage a short position just as you manage a long position.

How to Trade Coffee Futures

Holly Wilmeth/Getty Images

In terms of sheer monetary volume, coffee ranks at number two on the most commonly-traded commodities list. Coffee is perhaps one of the most interesting, yet volatile commodities to trade.

Coffee is a member of the soft commodities group along with other items grown by farmers, including sugar, orange juice, cocoa, and fruit. Most of these commodities, including coffee, are prone to wild swings in price, and traders must consider a variety of factors about coffee production and demand when making decisions regarding coffee futures.

Coffee Bean Types

There are two main types of coffee: Robusta and Arabica. The coffee traded on the Intercontinental Exchange (ICE) Futures contract in the U.S. is Arabica. The Robusta coffee beans trade at higher prices, in large part due to the demand from large, global customers including Sara Lee, Kraft, Proctor & Gamble, and Nestlé.

These companies together purchase almost 50 percent of all coffee produced worldwide, and they’re known as the “Big 4” coffee roasters. These companies own many coffee-related brands and produce coffee products under various names. Because of the volume of coffee these enterprises purchase, any changes in their demand can affect the prices of coffee futures.

The Arabica bean may be considered higher quality by some in the coffee industry, and you’re likely drinking Arabica bean coffee when you buy Starbucks or other premium coffees.

Regarding trading coffee futures, for simplicity, this article will focus on Arabica beans. The fundamentals of Robusta can affect Arabica prices because Robusta is a very close substitute.

Arabica beans are predominately grown in Brazil, while Columbia is the second largest producer. They are also grown in Central America, but most coffee traders focus on Brazil when they are trading coffee.

Weather Effects

Coffee grows on small trees, so the crops stay in the ground all year. This makes them susceptible to the elements of weather. The trees must flower each spring to produce a good crop, and it’s important to have weather that’s conducive to the trees blooming successfully during this period.

Weather plays a big role in coffee production. Prolonged periods of excessive moisture or dry weather can affect the yield numbers. However, frost or a freeze poses the biggest threat to coffee production. The coffee growing seasons are the opposite of the U.S. since the main crop-growing countries exist in the southern hemisphere.

Most of the biggest moves in coffee prices happen because the trees get damaged by cold weather. Tread carefully when trading coffee futures if the weather forecasts call for extreme cold weather. Coffee can move very quickly and prices will jump higher than many expect if a freeze hits the growing region of Brazil, for example.

Political Stability

Over 65 percent of the world’s coffee beans come from five countries, and if any of those countries experience political instability, this could affect coffee production, scarcity and consequently, prices. Brazil continues to produce over 30 percent of the world’s coffee, followed by Vietnam, then Columbia, Indonesia, and Ethiopia. The market responds very quickly to any events in these countries that could cause a drop in the coffee supply.

Increased Consumer Demand

The demand side also plays a large role in the price of coffee. Europe is the largest consumer of coffee, drinking more per capita in Europe than the rest of the world. The U.S. is also a significant consumer. Developing countries like China and South American countries continue to become more accustomed to coffee and may account for a substantial increase in demand in the coming decades.

Demand typically increases at a fairly reliable level, and people drink coffee in good times and bad. However, if an economy falls into a deep recession, demand for coffee, and likely all commodities, will decline.

Coffee Trading Tips

Coffee futures can make wide swings within each trading day. The extreme price variance makes coffee dangerous to trade on a short-term basis unless you can devote the time to monitoring the markets throughout the day. Successful trading also requires you to be disciplined, control your risk and get out of the market quickly if the trade doesn’t work. Taking profits at your objectives is critical, as the market price can turn very quickly.

Some traders prefer trading coffee over a longer-term horizon. This means looking for bigger moves in coffee over a matter of weeks, as opposed to trying to day-trade the coffee futures market. Sometimes, you may choose to take quick profits if the market makes a windfall move. However, it makes sense to look for larger moves that have a profit ratio of three to one or risking one dollar to make three.

You can also consider trading coffee by selling options instead of using futures contracts. Coffee options typically have a large amount of premium in them because of the market’s penchant for wide price swings. Options can work well in this market because they give you some cushion to withstand the price volatility.

For example, you can sell a put option on coffee, instead of purchasing a futures contract. Selling options carry a good deal of risk, similar to a futures contract. For those that do not trade in the futures market, a product such as the JO ETN has a high degree of correlation with price moves in the coffee futures market.

Many opportunities exist to trade coffee, especially if you can be careful and disciplined. Do your research and construct a trading plan. Get comfortable with cutting your losses quickly, and follow the market for a period, instead of jumping in on day one. The ETN product could be ideal for longer term trading positions as it carries less risk than futures or options. While the ETN can be volatile, it does not have the same degree of leverage as futures and futures options contracts.

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