I realize this is a coffee futures trading blog, but I don’t feel that futures trading is within the realm of reasonable money making for most people. It requires tremendous research, experience, and capital to consistently make money. And I speak from experience here, believe me, coffee futures have scalded me more than a few times. But this doesn’t change the fact that there is great money making potential in the futures market, despite the dramatic loss potential. And fortunately for those willing to take some risks, but not futures type risks, there are alternative investment strategies one can use to profit on the rise of futures contracts.

The Problem with Futures Trading
First, let’s make sure we’re on the same page when it comes to futures trading. I explain what futures are at length in Futures Trading for Beginners.  Futures, due to the incredible leverage, which acts as a double edged sword, makes them impractical investment vehicles for we sub-millionaires. What I mean by this is that to play the futures game, you must be a trader. You need to be focused on limiting losses and maximizing gains on every trade, all the while playing trade probabilities based on historical price movements and chart patterns. This requires dedication and constant attention. And you will lose at least some of the time.

Most futures traders have more than $50,000 dollars of equity to risk, and they tend not to risk more than 2% of their capital on any one trade. Talk about grinding it out. Nevertheless, because of the great leverage in futures trading, one can wait for a safe entry point, risk little, and potentially walk away with 3 or 4 winners that outweigh 10 losses. A good trader will be right somewhere between 40 and 60 percent of the time. This is why gamblers make better traders than surgeons or lawyers. A 60% success rate for a surgeon means 40 % of his patients have kicked the bucket under his knife. That doesn’t look too good. But if you shoot for perfection in futures trading (with a rare few exceptions out there), you will lose all very quickly.

But I digress. My purpose here is to discuss alternative investment strategies for one to profit from the impending Bull Run in coffee futures, applicable of course to long term bull runs in other commodity markets. As such, futures trading should be seen as a very short term approach, lasting minutes to a few days. But many of us believe the big money is in the trend, and this can last weeks to months to years. Unless you have millions and millions in your account, you will not be able to wait out a move like that in coffee futures without experiencing painful corrections that could wipe you out. So let’s look at a few alternatives for the long term investor that will limit risk while allowing them to stay the course.

Futures Options Investing
Most traders/investors do not ‘invest’ in futures options. Traders like them because they offer an edge in terms of probabilities. Sophisticated traders track risk quantifications and look to sell low risk options to traders who are full of hope or who are looking to hedge. For a more simplistic explanation of what futures options are, please read Commodity Futures and Futures Options.

Options trading does not need to be as complex as some make it out to be. If you were not looking to take advantage of risk imbalances or short term mathematical anomalies in the market, but merely to profit from a long term move in a commodity, options can provide a long term investment vehicle for holding tight through peaks and valleys.

At-the-money futures options that have about 4 months before expiration generally cost as much as a margin requirement on a futures contract. The entire value of the contract is time, as an at-the-money option has no inherent equity. This is generally too little time and too much money to risk on a contract that needs to rise considerably just for the investment to break even. If you believe your bull move will happen within 6 months to a year, you should try to purchase an option with a year to a year and a half of time before expiration. And you should look to purchase equity with that option as well as time.

Coffee futures right now are about $1.40. Let’s say a December $1.40 call option costs $5,000 and a December $1.30 call option costs $6,500 dollars (these are not today’s prices, I’m over simplifying). If you purchased the $1.40 call, you’d be buy 10 months of time, and zero equity. This means the market would need to rise 15 cents, just for you to break even. If you purchase the $1.30 call option however, you are buying 10 cents worth of equity, or $3,750 dollars worth. This means that you are only paying $2,750 for the time left on the contract. And while your maximum loss could still be 100% if the market collapses, when taking a longer term approach, buying in-the-money options adds a considerable cushion to the investment. The market would need to rise 7 or 8 cents for you to break even, and if it remains flat, your risk is half of what the at-the-money option offers.

But this has another, often unspoken benefit. Let’s assume that I’m confident about coffee making a run, which I am. For me to buy coffee futures and comfortably wait 10 months, I’d want to have at least 15 to 20 cents of safety to be sure I could hold out for that amount of time. This means that if I want to be long for 10 months, I should be able to risk 20 cents. If the contract costs $3,500, then that means I am going to risk 200% of my initial margin, which is a pretty terrible entry risk considering the market could correct that much, stop me out, and then recover leaving me at a huge loss without a position anymore. I can instead purchase an in-the-money call option, limit my total risk to $6,500, and wait out the market until it proves or disproves my suspicions.

That’s on the downside. Let’s assume coffee futures make a real run for it and shoot up 50 cents over the next month. I have the ability to exchange my option for the underlying futures contract. Now, if this was a risky thing in the first place, why would I want to do it now? Well, for two reasons. The first is that a deep in-the-money option is not always easy to sell immediately at your price. The second is because you cannot set a stop loss on an options contract, but you can on a futures contract. So if you own that option and the market falls, you’re going to have a hell of a time getting a decent price for it. If you have a futures contract, you can ensure a certain amount of profits will be retained.

So after you’ve protected yourself from unlimited risk and have been rewarded by selecting the right market, you can convert your contract, set a stop loss, and let the market tell you when it is finished rising. Otherwise you need to sell that option at a price you think makes sense, and that may be well in advance of the market top. But a stop loss allows you to lock in profits while at the same time allowing for further gains. It also allows you to use the equity in your contract to increase your position, or what is called pyramid your position.

Writing Futures Options
For those new to writing futures options please have a quick look at this lesson on Writing Call Options.  Now that we’ve finished talking about long term strategies for buying and holding options, we should talk about the other side of that equation. Just as you can purchase an option, you can also sell, write, or create an option from nothing and sell it to someone else. This, my dear friends, is modern day alchemy. With a bit of study, a bit of risk capital, and some big balls, you can essentially write your own check this way. You are selling hope, the hope that the market will go up or down, to someone looking to profit from either movement. When you write an option, the price of that option is debited to your account. That’s right, you sold an option to buy something that doesn’t exist, and it’s lining your pockets. The downside is that if the market goes their way and not yours, you are accountable for infinite risk. Their profit is your direct loss. Therefore writing options has all of the risk of a buying a futures contract, with none of the rewards.

Let’s stay with our frequent example here and say that you’re still bullish on coffee futures…or rather, not at all bearish. The beauty of writing options is that the market doesn’t have to go away from you to make money; it can also stay flat, or even move toward your strike price as long as it does not cross that price by expiration. Anyway, let’s assume you’re bullish on coffee futures, and futures trading is too risky, and options investing is too pricy. You can write out-of-the-money put options as the price of coffee rises and simply collect on lost hope. Someone else may think coffee is overpriced and want to purchase coffee puts in order to hedge a larger position or to profit from price collapse. You can sell this hope and security to them.

As coffee futures are presently approximately $1.40 and sitting on the long term trend line, the margin of safety here is significant for someone looking to go long. It is more significant for those who are looking to not go short, as you can comfortably write short term (1 to 3 months) out-of-the-money $1.30 puts and wait until they expire worthless. This can be done over and over again, forever. And as coffee futures rise, as we suspect they will, you can continue selling insurance for those who are long the market. It’s steady money, but it isn’t without risk. And I implore you; do not sell puts in June for this market, as coffee has a vicious seasonal downswing every year. That may be a good time to reverse your position and write call options to those expecting further price climb.

Investing in Commodity ETF’s
Well, this was the section I had in mind when I sat down to write this post. As usual I got carried away. Let’s leave aside the possibility of leveraged ETF’s, which do exist, and simply talk about regular Exchange Traded Funds. For those lacking the time, knowledge, or money to utilize the options above, you don’t have to fear missing coffee futures rise to the highest prices in 10 years. There are commodity ETF’s which track commodities, eliminating much of the risk (and much of the reward) inherent in futures trading.

Trading an ETF is akin to trading a stock or a commodity, which is not the subject of this post. Investing in an ETF on the other hand can offer some of the unique commodity trading advantages while eliminating some of the futures trading risks. A coffee ETF will rise and fall in coordination with coffee futures prices. But removing that dangerous leverage allows you to trade as you would a stock, where rock bottom is zero, rather than risking infinite losses. You can remain long coffee as long as you like this way, without concern for sharp corrections or concern for coffee being delivered to your doorstep because you didn’t sell prior to contract settlement.

There is one major advantage to trading a commodity ETF, and that is ability to use the COT report. In long Term Coffee Trading and the COT Report I discuss how this insight to insider trading is a tremendous edge for the long term trader. The problem with it is it foretells moves well in advance, and remaining in a market long enough without being stopped or shaken out is quite challenging. Well with ETF’s that isn’t a problem. You can wait patiently until commercial traders are buying in droves and then step in to get you some. This will have you in the market before markup phases or volatile trade occurs. You’ll be early and in at rock bottom prices.

As prices start to raise you can place stop losses at long term trend lines or moving averages to ensure or lock in profits. This is a long term trading strategy that may not promise the highest possible return, but it will offer the easiest long term money. One option is the coffee ETF COFF. This ETF is 100% invested in coffee and is a managed account that trades coffee futures. You however do not trade coffee futures, you simply buy and hold the fund. Not a bad setup.

This week offered a few valuable technical contributions to the coffee futures trading picture. Coffee futures, though still somewhat gripped by external markets, are and have been observing their own technical boundaries quite well. And this is exactly what a trader needs if he is going to have confidence in his own trading.

There are a few things I’d like to discuss here. We have in The Commitment of Traders Report and Coffee Futures discussed the importance of different trader groups in influencing long term price movements. And I think it’s important at this time to review that little lesson with specific examples. To be successful in futures trading you need reliable indicators. Indicators in themselves are nothing if not pattern finders, methods by which to compare the present to the past.

And the COT report, as I’ve already discussed, has above average predictive accuracy in futures trading, and nearly perfect predictive accuracy in coffee futures. At the time of the last post I showed you how commercial traders were net long back in December (signified by the red line being above the zero line), and I discussed how this is a demonstration of a long term value zone, one which should hold and before long prove to be cheap.

Well this value zone was tested again in February, and surprise surprise, it held. But hidden within the COT report was a valuable tidbit that I’m sure went overlooked by many futures traders. As coffee futures retested the lows at $1.05, the commercial position became net long again, but not to the same degree. This means that less commercial interest was required to support the market, and speculative traders and trend followers are adding a voice to the long side of the market.

You see, commercial traders don’t cause trends. They predict and/or cause bottoms and tops. It requires the fuel of speculative investment to move prices in one direction for any length of time. And the last low in coffee futures confirmed that there is more than commercial buying occurring. Why, you may ask, am I so confident that this market will trend higher from here? And how can I be so confident over the simple fact of commercial interest in this market?

Let’s compare the chart above to one from the lows of 2007. In this chart from 07 we see a textbook case of commercial buying (the red line), where after the bottom was caused we see positions oscillating in contradiction to prices. And notice after the lows were formed, commercial interest went negative (red line dropped below the zero line). Prices moved higher, and came back down, again meeting more commercial buying (or less hedging). The lows were set in at $1.05, and confirmed when prices retracted to $1.10 and rallied. That confirmation looks to me nearly identical to the one we see at present in coffee futures.  Though the commercial position in the 2009 in chart is much more bullish.

And for those of you who have been futures trading for any length of time will know, after the confirmation of the coffee futures bottom in July of 07, we saw prices rise 60 cents in the following 8 months, the majority of which accomplished between October 07 and March of 08. This was a pretty healthy chunk of profit for all those who heeded the crystal clear message the commercial traders were foretelling. Will history repeat itself here in the spring of 09? I believe so.

This third chart contains two of the most basic and useful technical indicators. Their place in futures trading is so well established I’d be very surprised if they aren’t followed religiously by more than 80 percent of professionals. The upper half of the chart, which also contains the daily price bars for coffee futures, has three lines waving all over the place. These are called moving averages, the average of a certain number of preceding daily prices. The ones I want to point out, and the ones most useful for longer term futures trading, are the green line, representing an 18 day moving average, and the blue line, representing a 40 day moving average.

If you look carefully you’ll notice that after prices cross the blue line, they remain on that side for quite some time. We have only seen prices cross the 40 day MA 3 times in the last 6 months. Before I point out a similar case in the 18 day MA, I need to explain what constitutes a confirmed change of trend according to most technicians. You see, it isn’t enough for prices to cross and close above the MA. This can happen quite frequently in shorter duration moving averages. Trend changes need to be confirmed by a second daily price closing that exceeds the closing price of the first daily price crossing.

In the last six months, despite their wily meandering and sporadic crossing of the 18 day MA, coffee futures prices again only had 3 confirmations in change of trend. Someone that followed this rule for the last six months would have made a profit if following the 18 day MA, and just broke even if following the 40 day MA. The value in these is not so much in picking bottoms and tops, but in giving us relative value zones within established trends. When there is no trend, they screw you.

I believe we have seen the bottom, and I took a position when prices were down in the $1.07 region. Prices have since rebounded, and this week sold off a little to the 18 and 40 day MA’s. As they did, I added to my position…one Sept. of 09 $1.15 Coffee call option. I want a long term position in this market and I don’t want to be shaken out of a futures position. So at present I am long one May future and one September call option. I purchased the futures contract based on commercial positions when I had a low risk entry point. And I purchased the call option on a return to long term value as defined by the longer term MA’s. We all need indicators that define ‘cheap’ and ‘expensive’.

The second factor I used to determine the purchase of the future, as commercial trading position alone is not enough to indicate a change of trend, was the MACD Histogram shown on the bottom of the chart. MA stands for moving average, and CD stands for convergence divergence. As you can see from moving averages charts, using more than one MA will show convergence and divergence as prices fluctuate. And because moving averages are lagging indicators, they have little predictive value. Plotting the convergence and divergence of these MA’s in a histogram shows us the rate of change of separation of the lines, and allows us to anticipate price changes.

A confirmed buy signal using the MACD Histogram is when you have two valleys separated by a peak of any magnitude, and the second valley is shallower than the previous one (and this is very important. The futures price, at the time of the shallower valley, needs to be cheaper than it was at the time of the larger valley). The middle of February was marked with a very deep valley in the MACD, which coincided with a large decline in prices. The beginning of March was also market by lower prices, but the MACD was shallower than before. This is called bullish divergence, and is a long term buy signal. And so I bought with a tight stop loss, which proved unnecessary as prices quickly moved higher.

Futures trading, as I’ve mentioned previously, is anything but methodical and orderly. It is chaotic and stressful. As such it is imperative that you find something in this game to give you an edge. Just as learning the odds in poker does not guarantee you a winning hand, it does provide an edge that with dedication and long term play will suggest consistent gains. We all need to find indicators that mesh well with the way we conceive of the markets in general, as well ones that fit our particular market if we intend to specialize. These are a few of the indicators I highly recommend for those interested in coffee futures trading.

Futures Trading is as complicated as it sounds, and as risky as people make it out to be. But once a basic understanding of the way the futures markets work, and a working knowledge of one or two commodities or stock index futures is had, futures trading can be a risk well worth taking.

Futures, as the name implies, are contracts on an asset to be delivered at some future date. To make these examples simpler to understand, I’ll use our beloved coffee futures as an example. Coffee futures are traded for five months throughout the year. Which means that if I purchase one May futures contract, and I don’t liquidate (or sell) that contract before it expires, then some time in early may 37,500 lbs of coffee will show up in a warehouse with my name on it and a rather large bill. If I sell this contract prior to expiration however, I only need to worry about profit and loss as related to the paper contract itself, the price of which is determined through free trade on the ICE exchange.

For any commodity, there are a few factors we need to understand before entering a position:
1. What is the size of the contract per commodity?
2. What is the margin requirement and maintenance margin requirement?
3. On a relative basis, how volatile is my chosen market?

(Notice here I am not discussing fundamental factors. While these do influence futures in the long run, they are a futures trader’s worst enemy in the short term. Investing and trading, while in principle are virtually the same, they differ in duration, and this makes them nearly diametrically different in practice.)

The size of the contract is important because it tells me the significance of price movements as it relates to my own profit or loss in that market. For example, a coffee futures contract, as we said, is 37,500 lbs. This means that for every penny that the price raises, I make $375. Likewise, for every penny that coffee futures fall, I lose $375. Depending on my risk tolerance or whether I am trading for short term or long term gains, this knowledge allows me to create a risk-reward money management system for this commodity.

In case you haven’t noticed, one coffee contract is worth a great deal of coffee and cash. And the price of a full contract is too rich for the blood of most speculators. Futures trading allows speculators to own enormous quantities of a commodity for a small sum of money, called margin. At present, the initial margin requirement on a coffee futures contract is in the neighborhood of $3,000. So for that small sum I can control a contract that at current prices represents approximately $45,000. That my friends is the definition of leverage, and there is no investment category out there with more leverage than futures trading. (Possible exception being real estate)

If the price rises a mere 10 cents, then I more than double my initial margin. If coffee futures fall a mere 10 cents, then I lose more than 100 percent of my risk capital. This is where the game shakes out those with a weak stomach. Because of the immense leverage, it is essential to trade according to a reliable system that incorporates both reliable technical indicators and sound money management practices. These are large topics themselves beyond the scope of this post. Nevertheless, they should be structured carefully around our third factor, volatility of our chosen market.

Futures trading is not only notoriously difficult to make money in, futures markets are also notoriously erratic and unpredictable, at least in the short term. Volatility is an inherent characteristic of free trade. The markets are in a constant state of flux, never remaining at one price for longer than a few seconds. So as we select a market, volatility should be a determining factor. Let’s say I have a $20,000 trading account (too small for a beginner), and I want to trade a market like coffee.

At present coffee futures are not terribly volatile (compared to its historic levels). Prices will fluctuate 1 to 8 cents a day. This means that if I want to give this market enough time to make me some money, I probably need to risk 10 cents so I don’t get stopped out on a simple price drop, in addition to buying strategically. This would require me to risk about 20 % of my account equity on a single trade, far too much to risk on a single trade.

Most money management systems consider risking anything more than 5% on a single trade careless, and most professionals don’t risk more than 2 %. This requires either a large trading account, or limiting your trading to markets that are less volatile or require less risk capital. Sugar or cotton futures may be an alternative. Something all those out there should keep in mind is that you are going to lose money in this game in the beginning. And the smarter you think you are, the more you stand to lose.

Futures trading requires you to think in terms of probabilities, and most people of average to high intelligence think in terms of absolutes. And because intelligent people are confident, they don’t take prudent precautions from unforeseen potentialities and their own ignorance. Doctors and lawyers throw a great deal of money into the futures markets and they are notoriously bad traders.

If you are right 60% of the time in futures trading and you apply a sound money management system, that is enough for you to make a great deal of money in the long run. If you’re right 60% of the time as a doctor or lawyer you kill clients and get canned. Futures trading requires you to think in terms of minimizing risk, an exceedingly difficult concept to apply when you believe you’re right about a trade (I speak from personal experience here). It is those who are convinced their view is right who lose the most money. It is the experienced speculator who lets the market tell him he’s right, rather than assuming the market will eventually capitulate to his convictions.

Trading this way requires you to find a system that defines your risk per trade based on the size of your account equity. This system needs to assume that you are going to be wrong 40 or 50 % of the time, and still needs to show you a healthy return on investment. Sound strange? I thought so too at first. Read a book or two on betting strategy in gambling, it will give you a sobering look at a long term risk-reward strategy based on probabilities. This system should contain indicators that define and identify trends, ranges, and reversals. These are indicators which in essence show us market sentiment.

In every price move there is a story of two forces colliding, a battle on the day, week, or month. Indicators should do more than interpret the past price movements, they should read the complex psychological factors influencing the current price. They should tell us when bulls are gaining strength, and when bears are getting tired. They should tell us when all the buying has been done on a long term historical basis, and if these forces are growing in strength or weakening. The best resource I have for all this is A. Elder’s “Trading for a Living”. This book contains 80 % of all the futures trading info you will ever need to learn. The other 20 % will come from studying the markets and getting burned a few times.

Regardless of the pain and suffering futures trading has put me through at times, it has enriched my life all the more. I can’t imagine my life without it.