NAVIGATING THE FICKLE "C" MARKET

Options for protecting your margin

THE ECONOMY IS tanking, there are rumors of specialty roasters going bankrupt and your $8-per-pound wholesale business is under attack. Several of your coffee retailer accounts have hinted at asking for a price reduction. “There are other options we have to consider,” they say. You can see their volumes have fallen by 20 percent. Is the writing on the wall?
     In the midst of this fearful storm, you receive a request from a gourmet grocery that would like to put your product on shelves in four stores. Higher powers must surely be caring for you!
     Shortly after meeting with the grocer’s purchasing manager, you realize that your profit margin must be crunched within 15 percent and your price guaranteed for six months at a time. The joy of the sales opportunity quickly turns to stress as you contemplate how you will ever be able to honor that guarantee. You remember that just two years ago the New York “C” market climbed to more than $1.70 per pound, far more than the 20-plus-percent margin you have in the $1.30s market of today. If the market repeats itself, your specialty green coffee prices will climb penny for penny.
     How can you protect your sales offer for six months at a time? How can a roaster insure a price while maintaining the ability to buy specialty coffees? Welcome to the world of hedging for the specialty coffee roaster. While there are a number of hedging mechanisms a roaster can employ, the call option on the coffee “C” futures contract is a viable way for specialty roasters to protect their costs. The use of “calls” can be thought of as modest capital investment allocated to price insurance for specialty roasters.
     This article draws on actual price data from a specific time period to show how roasters can use call option as a tool to protect their costs. To explain how to use the call option hedge, we are making the following assumptions:

• First, roasters have been introduced to the fundamentals of the coffee futures market and understand that specialty coffee prices are linked and compared to that market. This is referred to as the “differential.” This article assumes that these “differentials” will remain constant.

• Second, most specialty roasters have a relatively large gross profit margin, which they currently use as their default “insurance policy”—meaning they give up potential profits at times when the market rises and earn windfall profits when the market dips.

• Third, roasters need to protect their coffee supplies from dramatic market price spikes with low capital investments. Roasters can use a portion of their gross profit margin to insure their costs of goods through a call option, which in turn will allow roasters to compete for those wholesale accounts.

Using options for price insurance must not be confused with “speculating.” Speculators attempt to profit through the purchase and sale of futures and options contracts based on their prediction of what the market’s price will do in the future. “Hedgers” attempt to use the futures or options market to protect themselves from adverse price changes in the market. Most hedgers never take, or make, physical coffee deliveries from the New York Board of Trade (NYBOT); rather, they use the contracts for price protection against their physical contracts. Thus, roasters try to protect themselves from market price spikes, and producers seek to protect themselves from falling market prices.
     Coffee “C” options on futures are traded at NYBOT—now owned by InterContinental Exchange (ICE) —both by open outcry on the trading floor in New York and electronically. The technical definition of an “option” is a contract between two parties that conveys the right, but not obligation, for the option purchaser to assume a long or short position in the underlying futures market (NYBOT “C” market) at a specific price (strike price), for a specific time (expiration) and for an agreed price (premium). Buyers (roasters) can purchase “calls” to protect against market spikes. Suppliers (producers) can purchase “puts” to protect against falling market prices. Each pays a premium for this protection. The more protection desired, the more the cost of the insurance.

The Call Hedge Illustrated

To illustrate the use of the call option, let’s continue the introductory scenario and follow the steps a roaster could have taken in November 2007 to protect the wholesale proposal. Suppose that the specialty roaster purchases 150,000 pounds of certified-organic green coffee annually from several independent importers and origins. Many roasters work with their importers to hedge, but this roaster prefers the flexibility of working with a variety of importers, eliminating the ability to hedge with any given importer due to low volume. The average differential price paid for nine coffees in the lineup is +$0.65 over the NY “C” price. While origins may randomly have differential spikes unrelated to the NY “C”, the nine coffee average differentials tend to float with the NY “C” price. Let’s assume that this roaster’s costs of goods (green coffee costs) related to the NY “C” are fairly stable.

[Step 1]
Determine how many months of price protection are needed

The roaster would like to make a wholesale offer on that grocery account with a fixed sales price for six months and desires to protect the cost of goods represented in the offer through a call option purchase. In order to do that, the roaster would first project the volumes to be purchased in container-sized increments of 37,500 pounds, the NY “C” standard contract size. This weight is the unit multiplier for calculating the actual cash cost of a call premium (see Tables 2 and 3, pg. 25). In other words, the call premium is listed in cents per pound, and the total cash value paid for that call is then multiplied by 37,500 pounds. A call with a 5-cent premium would cost $1,875 ($0.05 x 37,500 pounds per contract).
     For illustration’s sake, let’s assume the roaster’s six-month projected consolidated use of the nine coffees falls into two 37,500-pound time periods: December–February and March–May. This roaster already has contracts with importers for approximately three months of use but in February or March will need to make additional purchases to cover the coffee supplies through May. Thus, the roaster needs to protect the second half of the supply for the wholesale contract, approximately through the end of March. To do that, the roaster will purchase a call that expires after its green coffee purchases, in this case a May call. This ensures price protection for the full term of exposure.

[Step 2]
Quantify your price risk

The next step is to calculate at what increased NY “C” price the reduced margins become undesirable. How much of a cents-per-pound increase in green-coffee costs is the roaster willing to have unprotected (in other words, what is the margin of play)? This provides a starting point to determine the strike price for the call purchase.
     In our scenario, the roaster has determined that a 10-percent increase in the NY “C” is where he would like to begin protecting his margin (Table 1, right). On November 21, 2007, the NY “C” May 2008 price was at $1.27. He would then consider buying a call at no higher than a $1.40 strike price. This would allow a partially unprotected margin of play of 13 cents per pound.

[Step 3]
Determine the cost of the protection

After the relative desired strike price is determined, the roaster must establish the premium, or cost, of the call. Options are traded in much less volume than futures; thus, the price you see online from the exchange ICE may not accurately reflect the actual momentary traded price of the call at any given time. To get a current call price, contact your futures and options broker.
     Table 2 (right) shows the November 2, 2007 call price for a May 2008 call at a $1.40 strike. The prices are listed in hundredths of a cent, up two decimal places. In our example, the call closing premium was 4.38, or $0.0438 per pound. For the purpose of illustration, we assume the roaster was able to buy the May 2008 $1.40 call for $0.05, spending $1,875 (see Table 3, right).

[Step 4]
Incorporate the cost of protection into cost of goods

Incorporating the cost of price protection into the roaster’s cost of goods is an essential factor that the roaster needs to consider when deciding whether or not to make a wholesale offer at reduced gross profit margins. Roasters also need to determine the maximum premium they can add to their cost of goods. It is important to remember that more protection costs more money. So how much “margin of play” can be allocated for insurance?
     In our scenario, the roaster adds the $0.05 as an additional outlay to its green-coffee cost of goods, bringing the total average green-coffee cost to $1.97—versus $1.92 without the call (see Table 4 on page 28). If the NY “C” significantly drops, the value of the call will be lost and the roaster has to be prepared to consider the price protection outlay a loss. This is similar in concept to an insurance policy. If you never get in a car accident you do not receive a return on your policy—but if you did, you’d be happy you had the car insurance.



     On the other hand, unlike car insurance, if the market drops and the roaster does not use the call, the roasters green-coffee costs should drop as well. This will offset the loss incurred due to the expiration of the call.
     In our scenario, the roaster’s maximum green-coffee price would have been $1.97 per pound ($1.92 + $0.05), and could be significantly less. But for our illustration, we want to see what happens if the NY “C” goes up—the actual risk that roasters desire to protect themselves from (see Table 4).

[Step 5]
Open a futures and options account

A broker can help with this process. Corporate account applications will require submission of financial statements and articles of incorporation. Accounts may take a few weeks to get established. An account owner (roaster) is not required to fund the account until hedging starts. Once the account is established, firms accept wire transfers, typically the same day. Thus, there is no financial obligation until the account owner decides to initiate a hedge.
     For our illustration, we will assume the roaster already has an account established and simply needs to make the decision to fund and use the account.

[Step 6]
Formulate your wholesale offer

Once the futures and options account is established, the roaster can consult with his broker to determine the price of the call option (steps 1–4) and make the wholesale offer. Establishing the account in advance, as in our case study, is a crucial step in being able to make a timely decision to propose a formalized wholesale offer based on real-time costs of goods and incorporated call costs.
     The roaster should consider a reduced time of validity for the offer of fixed-price wholesale contracts, requiring the potential customer to respond to the offer within a set time period, or include a clause that allows the final price to be renegotiated at the time the wholesale contract is signed. This will minimize exposure to significant market spikes, which historically can have the volatility of more than $0.05 per pound in one trading day.

[Step 7]
Fund the futures and options account

Upon first indication that the wholesale customer will accept the offer, the roaster should fund the account (if the roaster has not already done so). Funds must be in the account prior to executing a trade (most firms accept wires and can book contracts the same business day that the wire is received). In our scenario we’ll assume the roaster will go ahead with buying the May $1.40 call for $0.05, in which case he’ll need to have a cash balance of $1,875, plus corresponding fees. The total fees will vary from broker to broker.

[Step 8]
Purchase the call

Upon immediate confirmation of the wholesale sales contract, the roaster will purchase the call(s) necessary to protect the offer. The roaster repeats step 3 with its broker and confirms that the call premium is close, if not equal to, its original estimate. If so, the roaster then purchases the call.
     In our case study on November 2, 2007, the roaster contacted his broker via instant messenger and requested a quote for the May 2008 $1.40 call strike price. The broker responded moments later that the price was $0.05, and the roaster gave the order to purchase one May 2008 call with a cash withdrawal from its futures and options account.

[Step 9]
Monitor and sell the call

After purchasing the call, the roaster maintains contact with its broker and continues to watch the market. The roaster begins to consider locking in its Central American coffee purchases. As the end of the fiscal year approaches, the roaster consults with its tax accountant to correctly account for the value of the call(s) it owns.
     By February 2008, the market had climbed more than $0.30, and the roaster’s list of importers begins to offer fresh crop Central American coffees. On February 21, 2008, the roaster decides to lock in its coffee purchase with its importers to insure its green coffee through May. The May market price that day was $1.59, or $0.32 higher than it had been in November (see Table 4).
     The same day, the roaster contacts its futures and options broker and gives the order to sell its call. The call had gained value and increased to $0.20, resulting in $0.15 per pound hedge revenue to its hedge account. This hedge revenue can then be directly applied against the roaster’s green-coffee costs, offsetting the costs paid out for the coffee of $2.24 per pound and resulting in total green-coffee costs of $2.09 per pound (see Table 4).
     The direct result is that the roaster’s green-coffee costs went up 17 cents per pound (9 percent), compared with the 32 cents (17 percent) of the market. While not a one-to-one protection, this did allow the roaster to stay within the 10-percent margin it set out to be protected from, and the total capital cost was only $1,875—far less than buying a container’s worth of coffee in November 2007.
     If the roaster needed the cash influx, it could wire the $5,625 (see Table 3) hedge revenue, in part or whole, to its bank, though it probably would want to leave a portion of the profit to reinvest in continued price protection. If the market price would have fallen, the call “insurance” would have been allowed to expire, and the roaster would have lost the value of that call.

[Step 10]
Evaluate the hedge

Did the hedge achieve the roaster’s goals? Are there adjustments that need to be made for the next transaction? Did the timing of the hedge function properly and effectively?

In conclusion, protecting prices with call options can be effective for specialty roasters for three reasons:

1. Purchase price can be protected if the market rises drastically. The higher price paid for coffee in the cash market may be partially offset by a gain in the value of the option(s) owned.

2. If prices fall, the option will expire worthless. While the investment in the price insurance will be a total loss, this leaves the roaster with no obligation to the option and with the advantage of purchasing coffee at the lower price. The loss is limited to the premium paid for the protection, plus the broker fees paid for the execution (usually less than $75).

3. The call hedge can be a relatively small capital and cash-flow-sensitive investment for price protection when compared to owning outright six months of green coffee stock at a time.

Protecting from unforeseen NY “C” price shifts is an essential practice for growing a healthy wholesale coffee business. Hedging empowers roasters to access markets that otherwise would be impossible to penetrate. For the traditional wholesale model it enables roasters to offer the most competitive extended fixed-priced bids, giving them the greatest chance to win those higher-volume accounts.
     For the super-quality direct-trade model, hedging allows you to pass on market upswings to your producer partners. A built-in hedging cost on behalf of the producers empowers you to maintain significant market plus differentials, regardless of market spikes, which in turn will further ensure farmer motivation and your reception of that elusive effort-filled 88+ cup.
     Whether your need is to protect your margin or your direct-trade producer’s margins, the call hedge can be one of the specialty-roasting community’s most effective price-insurance tools. While they can be complicated, we hope this illustration will pique your interest in investigating further how you might be able to protect your margin with calls.

K.C. O’KEEFE is a specialty coffee consultant and trainer who specializes in green-coffee sourcing and quality-control management for producers and roasters. His e-mail is kc@cafeverdeperu.com.

GREG PARKS & ANDREW KACZkOWSKI are Chicago-based futures and options brokers with Providio Trading. They have more than 40 years of combined experience in the commodity futures and options industry.