Martin Kronicle

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I thought I’d save two birds with one blog post. A reader of mine kindly suggested that I write more about options, so I’m going to do that wrt to the WSJ article today entitled Coffee Futures Are Near A 13-Year High.

From the article:

Coffee futures remain close to a 13-year high, as tight supplies and the prospect of dry weather hurting next year’s Brazilian crop have sent roasters scrambling to secure beans.

So if we are at multi-year highs, you might be bullish but are scared to enter the market at these levels. One of the ways you can be bullish and limit your downside is with options.

Notice that being scared is a function of fear, an emotion, and is not a financial term, yet it can have a profound effect on your finances. Smart financial decisions rarely feel good, but I digress…

Instead of buying December Coffee futures and posting the initial margin of $7,700 for the directional trade, you can use call options to capture the upside. It’s true you can cut your initial margin substantially if you just bought outright calls, but today I’m going to show you how to implement a Bull Call Spread — a position where you are simultaneously long and short 2 calls in the same account. [Trade this at your own risk. This is for educational purposes only.]

Click for a larger and clearer picture.

Options are all about floors and ceilings. You determine those floors and ceilings by the Strike Prices you select. They are probably the one instrument that you can trade that you can use to bet where the market IS NOT going to go, as much as where it might go.

In order to implement the Bull Call Spread, you need to buy the lower strike price and sell the upper strike price. In this case, I’ve chosen a call that is close to being At-The-Money and one that is 10 points higher. [see the chart above and the highlighted prices].

Buy the November 182.50 Call at 4.94 (a debit)
Sell the November 192.50 Call at 1.94 (a credit)

This will create a net debit of 3.00 or $1,125 per spread. This is your total cost to own the spread — it is also your maximum loss on the trade. [You get this number my multiplying .03 by 37,500 lbs - the size of the standardized contracts. Three points is represented as .03]

Keep in mind that if you have $25,000 in your account, you’re looking at risking 4% of your capital on this spread. That’s very aggressive to put it in perspective, and I’d say that there’s not enough equity in your account to withstand the emotional hit of losing that 4% several times in a row. An account with $100,000 would be more like it — and that’s true even though the spread itself is considered to be more conservative a trade than an outright, directional trade in coffee futures.

Any time you have a debit or a net debit, that represents your Max Loss on the trade. Don’t forget, if you trade the coffee futures outright, long or short, you always have unlimited loss potential.

In this case, you are saying “I’m bullish above 182.50 but only up to 192.50.” Because you are only bullish up to a point (192.50), you are going to have the buyer of the 192.50 call pay you in order to help finance the purchase of your 182.50 call.

The beautiful thing about a spread like this is that everything that you can earn or lose takes place between the strike prices. Theoretically, the absolute value of the difference between the strike prices is equal to the sum of the max gain and the max loss. Let’s take a look:

|SP1 – SP2| = Max Loss + Max Gain

|192.50 – 182.50| = 3.00 + Max Gain

Therefore 7.00 points = Max Gain

The break-even is the net debit added to the lower strike price:

182.50 + 3.00 = 185.50

Notice that you have a better than 2:1 payoff in this case. That says nothing about the probabilities of either of those outcomes, but your are bullish and you are trading with the trend while prices are approaching multi-year highs.

Here’s a graphic depiction of what’s going on (please pardon my handwriting):

Click for larger and clearer picture

At 182.50 or below, you suffer a total loss. Between 182.50 and 185.50, you lose incrementally less as the price of the contract approaches the break-even (noted as B/E on the graph). Between 185.50 and 192.50 you profit, with profits increasing incrementally as the contract approaches 192.50 where you experience the feelings of the max gain.

Beyond 192.50 you get nothing more because you are capped at 192.50 – remember you sold the call to someone else and you are obligated to deliver coffee futures at that price. You are considered “covered” in this case because you own a lower strike price (has to be the same underlying mais bien sur!!!)

Spreads are about using those floors and ceilings to make financial trade-offs that you are willing to make. Instead of paying $1,852.50 (.0494 x 37,500) to own the 182.50 call option outright, and have the unlimited upside that goes with it, you are giving up the potential for unlimited upside for a lower cost of $1,125. In the process you are lowering your cost by $727.50 or almost 40%.

If the contract goes to 192.50 or higher, you’ll have a gain of $2,625 or about 133%.

This spread trade can be implemented by commodity hedgers too, whereby the gain to the investor would be the savings to the hedger.