Coffee is a wonderful commodity that ties together very exciting parts of the world. While one of the most popularly traded, it can also be one of the most volatile. At DRW, we’re very fortunate to bring our research and trading experience together and plug into the best in class thought process, dialogue and approach to risk. In this article, we’ll delve into our strategy for trading this commodity.
In coffee, there are 2 main ICE exchanges in the US and EU - Arabica and Robusta. Both with decent liquidity in futures, options, and down the curve. When evaluating which to trade, it’s more often the case that there is something we find interesting across spreads, options, outright direction or relative value. Fundamentally, we focus on the general balances of the market (surplus or deficits) over various time frames and determine whether these dynamics are concentrated in a particular geography, time of the year, and/or within a specific quality of coffee. Climate and Foreign Exchange markets can also be relevant to coffee price discovery on the terminal markets, sometimes acutely. Ultimately, our aim is to aggregate these factors to help us identify pockets of mis-pricings in the coffee landscape.
When it comes to our overall approach to the coffee market, it’s important we consider the following:
Liquidity Providing: We have seen coffee trade below cost of production as well as the highest price level in over a decade. While there have been valid reasons for both market environments, there have also been moments within these extremes where the commercial market has clearly been searching for institutional liquidity. As non-commercial market participants, we can provide a healthy balancing function to the market in these instances.
Algorithmic Trading: In coffee trading, there is a ton of data and it is highly fragmented causing us to interact and analyze a lot of it. Though our execution is not automated, we do integrate and codify the data we have and look to distill it down into market signals.
Risk-taking: When it comes to risk, acknowledging one’s limitations is key. We don’t own coffee farms or roasters and we aren’t present in the physical markets so at best our operations come from instances of where we can assign a high degree of confidence to a market assumption we have about the future. To take it one step further, we have to feel these views are contrarian and uncrowded. Accepting it this way helps in embracing risk, but also sizing appropriately.
With the opportunity sets in coffee, we often leverage all three of these approaches. Even though we trade one product because it is so multivariable, we can express different types of strategies ranging from event driven and yield oriented risk to fundamental value and trade flow driven starts. We’re clearly talking our own book here, but coffee is a fascinating commodity that presents great trading opportunities that leverage a variety of strategies!