Let’s have a look how could we profit by selling put options in cocoa futures.
I really like trading “soft markets”, but moreover, these markets provide a good opportunity for option sellers because they often have relatively high volatility.
Cocoa futures trade internationally at the futures exchange
First things first. I would like to begin with a short description of the cocoa futures.
Cocoa futures are traded at the Intercontinental Exchange (ICE) under the symbol “CC”. The symbol helps us to find the relevant futures contract or the relevant option in the trading account. Here, we are speaking about the commonly traded futures contract – U.S. Cocoa futures – not the London Cocoa Futures. Cocoa as a commodity belongs to the so-called “softs” together with coffee, sugar, cotton or orange juice. We might call them also exotics because of where they grow. One future contract includes 10 metric tons of cocoa. This means, one contract would be more than enough for a life-long-supply for the whole neighborhood. That is why, for what we do as small traders, we do not want any physical delivery of cocoa. Nowadays, the majority of brokers do not allow physical delivery anyway. Just to conclude, there are cocoa contracts for five different months: March, May, July, September, December.
This was the basic overview of cocoa futures to know a bit about the technicalities. Actually, I do not trade the futures contract themselves because I focus on selling options in the cocoa market, in this case put options. To find out more about options in general, check out the “OPTIONLAND”.
Action plan and reasons
The plan is to sell put options on cocoa futures, as I expect that the price of the March cocoa contract won’t go below a certain level, to be precise below 1850 in the next 69 days. Why do I think so? Let’s look at the reasons together:
It is always good to have some basic information about the factors influencing the supply and demand in the cocoa market so that one can understand how price for cocoa is being created. I personally consider just the very simple fundamental analysis to have at least the basic picture about how the market looks like.
To focus too deeply on detailed fundamental analysis might be definitely good for someone like Nestle, but for me as an option seller, knowing the basics should do the job.
The cocoa production is concentrated to just a few parts of the world. The major producers are Côte d’Ivoire and Ghana. These two West-African countries extremely increased the production in the last years which resulted in dropping cocoa price. It is unlikely that the increase will continue. On the opposite, Côte d’Ivoire and Ghana are now trying to stabilise the price as the relatively low prices of cocoa had a negative impact on their budget. Income from cocoa trade is extremely important for them as it constitutes a large part of the national budget.
The third largest producer is Indonesia where the production is expected to fall again.
I like to be bullish on cocoa
I like to be bullish on cocoa futures and I will explain why. As the production is concentrated to just a few small countries, every tiny problem in production may result in a price really. Côte d’Ivoire and Ghana do not belong to the most stable countries in the world. If there would be a conflict, that might paralyze the supply of cocoa beans. Also, the high production in the last years is partly due to output of non-authorized plantations in forested areas in Côte d’Ivoire. The government threatened to tackle this.
Besides any political problems, there is also the risk of a black pod disease which can destroy the crop. This fungal disease thrives in wet and damp conditions caused by heavy rain. Heavy rain is everything else than unusual in cocoa producing countries in Africa.
Companies like Nestle and Cadbury are well aware of the risks and hence, they have a strong presence in these countries to ensure that they will have access to cocoa to satisfy the world’s strong demand for chocolate. Cocoa butter and cocoa powder find its use not only in the confectionery industry, but also for example in cosmetics. So, the demand is there and it is strong.
Cocoa has built a nice bottom, the price stabilized and it has moved above the range of $1800-$2000 where it traded in the last few months.
Seasonally, the price of cocoa should be near the bottom at this time as well. From the second half of November, the price of cocoa used to raise. This obviously does not mean that it has to happen every year, but once you collect several such indicators, the odds will be on your side.
Last but not least, it is important to look at the implied volatility of cocoa futures. This is currently about 25%. The implied volatility moved in the last year in a range from 19.79% to 36.5%. Hence, the current implied volatility is not as high as it could be. I would more prefer a number of at least 27%, but 25% is ok. For those, who are not familiar with implied volatility, my previous article about Equifax explains it a bit. Basically, the higher the implied volatility, the better it is for an option seller. When the implied volatility is high the price for options is high and we can sell an option with a strike price very far out-of-the-money.
I expect that the price of March cocoa futures will not go below $1850. Ideally, the price will raise.
Therefore, I see an opportunity to selling put options on the March cocoa futures contract “CC” expiring on 5 January 2018 at the strike price 1850 while collecting a premium of $130 per option
As usual, I will let you know, here on Premium-Flow, when I close the trade or when something important happens.
In the meantime, let me know what you think about this trade in the comments below and stay well.