If you are bearish on coffee, you can profit from a fall in coffee price by buying (going long) coffee put options.
Example: Long Coffee Put Option
You observed that the near-month Euronext Robusta Coffee (No. 409) futures contract is trading at the price of USD 1,648 per tonne. A Euronext Coffee put option with the same expiration month and a nearby strike price of USD 1,600 is being priced at USD 109.87/ton. Since each underlying Euronext Robusta Coffee (No. 409) futures contract represents 10 tonnes of coffee, the premium you need to pay to own the put option is USD 1,099.
Assuming that by option expiration day, the price of the underlying coffee futures has fallen by 15% and is now trading at USD 1,401 per tonne. At this price, your put option is now in the money.
Gain from Put Option Exercise
By exercising your put option now, you get to assume a short position in the underlying coffee futures at the strike price of USD 1,600. In other words, it also means that you get to sell 10 tonnes of coffee at USD 1,600/ton on delivery day.
To take profit, you enter an offsetting long futures position in one contract of the underlying coffee futures at the market price of USD 1,401 per tonne, resulting in a gain of USD 199.00/ton. Since each Euronext Robusta Coffee (No. 409) put option covers 10 tonnes of coffee, gain from the long put position is USD 1,990. Deducting the initial premium of USD 1,099 you paid to purchase the put option, your net profit from the long put strategy will come to USD 891.30.
|Long Coffee Put Option Strategy|
|Gain from Option Exercise||=||(Option Strike Price – Market Price of Underlying Futures) x Contract Size|
|=||(USD 1,600/ton – USD 1,401/ton) x 10 ton|
|Investment||=||Initial Premium Paid|
|Net Profit||=||Gain from Option Exercise – Investment|
|=||USD 1,990 – USD 1,099|
|Return on Investment||=||81%|
Sell-to-Close Put Option
In practice, there is often no need to exercise the put option to realise the profit. You can close out the position by selling the put option in the options market via a sell-to-close transaction. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.
In the example above, since the sale is performed on option expiration day, there is virtually no time value left. The amount you will receive from the coffee option sale will be equal to it’s intrinsic value.