Cocoa Futures and Cocoa Options
Market
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Dear clients and students of the commodity markets, the
following information should answer all of your questions about cocoa futures
and cocoa options. You may also call 800-915-4716 or email
tkfutures@earthlink.net your cocoa future
and cocoa options questions to be answered by a seasoned professional.
The History of Cocoa and Cocoa Futures Trading
Cocoa was originally combined with spices and served as a luxury
drink in the Aztec empire. The Aztec Emperor,
Montezuma, shared the cocoa and spice beverage with
the explorer and later conqueror of the Aztecs,
Hernando Cortez. The cocoa was brought back to Spain
in the 16th century by Cortez and his Conquistadores. For nearly a century, chocolate
(usually made from cocoa, sugar, cinnamon and
vanilla) became an exclusive drink of the Spanish
Royal Court, until it gradually achieved a wider
popularity in cocoa houses of major European cities
when it became less expensive.
In
1828 cocoa began the great transformation from a
beverage to a solid form. The discovery was made that a liquid
cocoa butter (called liquor) could be pressed out of
ground cocoa beans and then used as a base to make
chocolate candy. Swiss candy maker Daniel Peter's
invention of milk chocolate 40 years later further
increased the attraction for chocolate and the
demand for cocoa beans.
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In
1925 the world's first cocoa bean future was started
at the New York Cocoa Exchange. In 1986 the first
cocoa options began trading. Cocoa future trading is
now a very active future trading contract. Cocoa
options on the cocoa futures contracts have enjoyed
much higher volume and consequently much greater
liquidity recently.
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During the September 11 terrorist attacks the
Coffee, Sugar and Cocoa Exchange (CSCE)
was destroyed but within days the cocoa futures and
cocoa options markets were once again trading. This
is a testament to the strength and viability of the
soft futures markets. The CSCE has since merged to become part of the New York Board
of Trade (NYBOT) who merged with the (ICE).
Contract Specifications for Cocoa Future contracts
Trading Unit
10
metric tons (22,046 pounds)
Trading
Hours
8:00 a.m. - 11:50 a.m.
closing period commences at 11:45 am (NY time)
Price
Quotation
Dollars per metric ton
Delivery
Months
March, May, July, September, December
Ticker
Symbol
CC
Minimum Fluctuation
$1.00/metric ton, equivalent to $10.00 per contract
and approximately 5/100 cent/lb.
First Notice Trading:
Ten business days prior to first business day of
delivery month.
Last Trading Day:
One business day prior to last notice day.
Cocoa Economics
Cocoa Supply
The cocoa trade is strictly a tropical plant,
thriving only in hot, rainy climates with
cultivation generally confined to areas not more
than 20 degrees north or south of the equator. The
tree takes four or five years after planting to
yield cocoa beans and from eight to ten years to
achieve maximum production. When ripe, these pods are
cut down and opened, and the beans are removed,
fermented and then they are dried.
The cocoa butter extracted from the bean is used in
a number of products, ranging from cosmetic to
pharmaceuticals, but its main use is in the
manufacture of chocolate candy.
Currently, the Ivory Coast and Ghana are the world's leading
cocoa producing nations. Recent estimates are 50% of the world's cocoa
originates there. Conflict in the Ivory Coast
region has hindered cocoa production and added
considerable volatility to the cocoa futures markets. Indonesia ranks
next among major world producers, followed by
Brazil, Nigeria and Malaysia.
Cocoa Demand
Recently, the leading cocoa bean
importing nations are the Netherlands, United States
and Germany. These countries accounted for about 54%
of world imports in the past. The U.S. is the
leading importer of cocoa products such as cocoa
butter, liquor, and powder - accounting for 12% of
world imports in recent years.
The Role of the Exchange and
Cocoa Futures
The (NYBOT) recently merged with the (ICE) and is the world's
premier forum for cocoa futures and options trading.
Cocoa future trading and cocoa option trading has gained much popularity in
recent years and liquidity has increased accordingly.
Trading Cocoa Futures
A
cocoa futures contract is a standardized, binding
agreement to make or take delivery of a specified
quantity and grade of a commodity at an established
point in the future and at an agreed upon price. A
contract buyer is obligated to take delivery of
cocoa according to contract terms at a specified
date, while sellers are obligated to make delivery.
Buyers are considered to be "long" and sellers
"short" the futures contract. "Standardized" means
the terms, size and duration of the contract are
predetermined and meet certain criteria. The only
negotiable variable is the contract price.
Margin
Toward ensuring contract performance, the Exchange
requires that market participants make original and
variation margin payments. Original margins are
"good faith deposits" established to ensure market
participants will meet their contractual financial
obligations.
Leverage
A
major attraction of cocoa futures trading for investors is
leverage. Since futures transactions do not require
full advance payment for the commodity (just the
margin), the buyer of a futures contract which
increases in value (or the seller of a futures
contract which decreases in value) can realize a
profit which can be substantial in relation to the
commitment of capital. Assume that an investor can
purchase cocoa futures contracts (each representing
10 metric tons of cocoa) with a $1,100 margin
deposit. If the investor bought one contract at
$1,250/metric ton (12,500 worth of cocoa) and sold
the contract when cocoa reached $1,410/metric ton,
he would realize a profit of $1,600 ($160 x 10
metric tons = $1,600) - a 145% return on the initial
margin deposit, which is returned when the position
is liquidated.
That's leverage, and it can be a powerful investment
tool. Of course, leverage works both ways. If
cocoa futures prices were to move opposite from the
anticipated direction, an investor could lose the
entire margin deposit and more. Futures trading is very risky.
Trading Cocoa Future Options
In 1986, cocoa futures options began trading. Because options
strategies are numerous and can be tailored to meet
a wide array of risk profiles, time horizons and
cost considerations, hedgers and investors alike are
increasingly realizing their vast potential. As a
result, cocoa options volume has grown considerably.
Buyers
Cocoa options buyers obtain the right, but not the
obligation, to enter the underlying cocoa futures market
at a predetermined price within a specific period of
time. A "call" option confers the right to buy (go
long) futures, while a "put" option confers the
right to sell (go short) futures. The predetermined
price is known as the "strike" or "exercise" price,
and the last day when an option may be exercised is
the "expiration date". Buyers pay sellers a premium
for their option rights.
Because an option holder is under no obligation to
enter the futures market, losses are strictly
limited to the purchase value: there are no margin
calls. If the underlying futures market moves
against an option position, the holder can simply
let the option expire worthless. On the opposite
side, potential gains are unlimited, net of the
premium cost. That feature allows hedgers to guard
against adverse price movements at a known cost
without foregoing the benefits of favorable price
movements. In an options hedge, gains are only
reduced by the premium paid - unlike a futures
hedge, where gains in the cash market are offset by
futures market losses.
Cocoa option holders can exit their position in one of
three ways: exercising the option and entering the
cocoa futures market, selling the option back in the
market, or letting the option expire worthless.
Sellers
Option sellers, or "writers", receive a premium for
granting option rights to buyers. In exchange for
the premium, writers assume the risk of being
assigned a position opposite that of the buyer in
the underlying futures market at any time prior to
expiration. Writers of call options must be prepared
to assume short positions at the option's strike
price at the option holder's discretion, while put
option writers may be assigned long futures
positions.
Writing put and call options can serve as a source
of additional income during relatively flat market
periods. Because option writers must be prepared to
enter the futures market at any time upon exercise,
they are required to maintain a margin account
similar to that of for futures. Sellers can offset
their positions by buying back their options in the
market.
Strike Prices
Traders agree on premiums in an open outcry auction
similar to that for futures contracts. The Exchange
generally lists seven strike prices for each option
month: one at or near the futures price, three above
and three below. As futures prices rise or fall,
higher or lower strike prices are introduced
according to a present formula.
Premiums
A
number of factors impact premium levels in the
market. "Intrinsic value" is the dollars and cents
difference between the cocoa option strike price and the
current cocoa futures price. An option with intrinsic
value has a strike price making it profitable to
exercise and is said to be "in-the-money" (strikes
below futures prices for calls, above for puts). An
option not profitable to exercise is
"out-of-the-money" (strikes above futures prices for
calls, below for puts). "At-the-money" options have
strike prices at or very near futures prices. In
general, an option's premium is at least equal to
its intrinsic value (the amount by which it is
"in-the-money").
"Time value" is the sum of money buyers are willing
to pay for an option over and above any intrinsic
value the option may presently have. Time value
reflects a buyer's anticipation that, at some point
prior to expiration, a change in the futures price
will result in an increase in the option's value.
The premium for an "out-of-the-money" option is
entirely a reflection of its time value.
Premiums are also affected by volatility in the
underlying cocoa futures market. Because high levels of
volatility increase the probability that an option
will become valuable to exercise, sellers command
larger premiums when markets are more volatile.
Finally, premiums are affected by supply and demand
forces and interest rates relative to alternative
investments.
Option Month
Cocoa options are traded on futures contracts having
March, May, July, September and December delivery
periods. The option month refers to the futures
contract delivery month rather than the month in
which the cocoa option actually expires.
In
general, the last trading day for cocoa options is
the first Friday of the month proceeding the cocoa futures
contract delivery month.
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Buying a Cocoa Call Option
Buying a call can be employed to profit from, or
achieve protection against, an increase in the price
of cocoa. Except for the cost of the option, the
profit potential is similar to having a long
position in the underlying cocoa futures contract.
Moreover, this strategy may provide greater "staying
power" in the event of a temporary price setback
than having an outright long futures position.
Reason: there are no margin calls because one cannot
lose more than the premium paid for the option.
For example, assume in July, an investor forecasts
higher cocoa prices by winter's onset. With December
futures trading at $1,100/metric ton, the investor
decides to purchase a December 1100 call (an
at-the-money option) for $95/metric ton. Since each
contract represents 10 metric tons of cocoa, the
total premium paid is $950.
The maximum loss the investor can incur is the
premium paid, regardless of how far futures prices
fall. However, the potential profit is unlimited
since the option holder gains dollar-for-dollar in
the rise of the underlying futures price minus the
cost of the premium.
Call options can be purchased for price protection
as well as for the pursuit of trading profits.
Commercial firms buying call options effectively
establish a maximum purchase cost equal to the
exercise price of the option plus the option
premium. Employed in this way, options offer hedgers
price "insurance", while at the same time allowing
them to benefit from price declines since they can
allow the option to expire unexercised.
Example: Buying a Cocoa Put Option
Whereas buyers of calls can profit from rising
prices, buyers of put options - rights to sell
futures contracts at the option exercise price - can
profit from price declines. Except for this
difference, the properties of puts and calls are the
same.
To
realize a profit at expiration, the underlying
futures price must be below the option exercise
price by an amount greater than the premium paid for
the option. If it is higher, a portion or the entire
premium will be lost. In no case, however, can
losses exceed the premium paid.
For example, the investor in February expecting
depressed cocoa prices during the summer can
purchase July puts. With July futures trading at
$1,200/metric ton, the investor purchases a July
1200 put for $100/metric ton ($100 x 10 metric ton =
$1,000 total).
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The investor can lose no more than the premium paid,
no matter how high cocoa futures prices climb. On the
other hand, if prices decline, the investor can
realize substantial gains. A cocoa futures sale at the
strike price would have similar profit opportunities
in a falling market - plus the premium paid to
obtain the option. However, losses from a short
cocoa futures position would be unlimited in a rising
market.
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