Considerations for Trading Coffee Futures

Guatemalan Coffee Beans
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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.