Cocoa Futures Options Trading

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Cocoa, originally combined with spices and served as a luxury drink in the Aztec empire, was brought back to Spain in the 16^th century by the 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.

In 1828, Conrad J. Van Houten, a Dutch manufacturer, began the great transformation of cocoa from a beverage to a solid form. He found 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.

Cocoa Economics

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. The fruit of the cocoa tree appears as pods primarily on the trees trunk and lower main branches. When ripe, these pods are cut down and opened, and the beans are removed, fermented and 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 is the world's leading cocoa producing nation. Ghana and Indonesia rank next among major world producers, followed by Brazil, Nigeria and Malaysia.

Demand

Cocoa is consumed predominantly in countries of relatively high income. Currently, the leading cocoa bean importing nations are the Netherlands, United States and Germany. These countries accounted for about 54% of world imports in 1995/96. The U.S. is the leading importer of cocoa products such as cocoa butter, liquor, and powder - accounting for 12% of world imports in 1995/96.

The Role of the Exchange

ICE Futures U.S. is the world's premier forum for cocoa futures and options trading.

As an exchange, ICE does not participate in cocoa price determination. Rather, it provides a visible, free market setting where members can conduct futures and options transactions subject to Exchange rules and regulations. Since all futures and options contracts are standardized (with delivery months and locations, quantity and grade constant), only price is negotiable. The Exchange environment allows prices to reach their natural levels - an important economic function known as price discovery.

Trading Cocoa Futures

A 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. Original margins are established by the Exchange and are periodically adjusted to reflect changing market conditions, especially price volatility. At the close of each trading day, margin accounts are "marked to the market"; that is, they are adjusted to reflect price movements in the futures markets each and every trading day. When prices move unfavorably to a trader's position, additional or variation margin payments are required to restore margin to original levels.

Leverage

A major attraction of 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 futures prices were to move opposite from the anticipated direction, an investor could lose the entire margin deposit and more.

Trading Cocoa Options

With its launch of options on world sugar futures in 1982, it became the first exchange to trade options on commodity futures. In 1986, options on cocoa futures commenced 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

Options buyers obtain the right, but not the obligation, to enter the underlying 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.

Option holders can exit their position in one of three ways: exercising the option and entering the 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. Chief among them is an option's intrinsic value. "Intrinsic value" is the dollars and cents difference between the option strike price and the current 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 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 option actually expires.

In general, the last trading day for cocoa options is the first Friday of the month preceding the futures contract delivery month.

To learn more about Cocoa futures and options, please contact our professional brokers at Infinity Trading Corporation.