Orange juice trading has become popular globally and trading volumes continue to increase. Being one of the world's most popular fruit juices, orange juice trading attracts a variety of market participants which include the farmers, processors, storage-houses, market makers and arbitrageurs. Multiple financial instruments, like futures and options, are available for trading orange juice. This article discusses options trading on orange juice contracts, trading scenarios, orange juice trading markets and participant profiles, the risks, rewards, and how the determining factors impact option prices for orange juice trading. Orange juice options on ICE futures exchange are taken as examples cited throughout the article.
Soft Commodities, which include cotton, cocoa, orange juice, coffee, sugar, are now finding place in trading portfolios of active market participants as an alternate class of tradable securities. Lack of storage and processing capabilities before 1950 restricted the orange juice to what was called a same-day consumption commodity or a perishable commodity. In the 1950s, the orange juice industry was revolutionized by the development of frozen concentrated orange juice (FCOJ). Through processing, freezing, and flavoring agents, orange juice became the world’s favorite fruit drink and the commodity that it is today.
While marketmaking, arbitrage, and speculation continue to remain the heart of trading, hedging is the primary purpose for which so many products continue to get enabled for trading on leading global exchanges. Hedging is accomplished by derivative products like futures and options which can be efficiently used by producers as well as consumers to accomplish risk management.
What is an Orange Juice Options Contract?
In orange juice options trading, the underlying asset is one FCOJ-A futures contract. One such futures contact is worth 15,000 pounds of concentrated orange juice solids. This means that if an orange juice option contract expires in-the-money (ITM), the buyer of the orange juice call/put option will get the right to enter into a long/short orange juice futures contract. He can then use that futures contract to take one of several actions: trade (sell/buy) the futures contract, exchange the contract for physical orange juice, or roll over the contract to the next term futures contract.
Example of Using Orange Juice Options for Hedging
For simplicity, all the below examples use one unit of frozen concentrated orange juice. Mentions of oranges or orange juice refer to one unit of frozen concentrated orange juice. Realistic calculations are provided in following sections.
Assume it is January and frozen concentrated orange juice is currently trading at 135 cents/pound (the spot price). An orange farmer expects his crop (1 unit of FCOJ, or 15,000 pounds) to be ready for sale by June (in six months). The farmer is nervous about a price drop in oranges in near future, so he wishes to secure the minimum sale price of oranges (to say around 130 cents/pound) for when his crop is ready. The farmer is looking for a hedge or price protection on his crop. To do this, he can buy one orange juice put option contract.
A put option gives the farmer the right to sell the underlying asset at a specified sell (or strike) price within a certain timeframe. The orange farmer selects the option contract with strike price of 135 cents and the expiry in June, which is when his crop will be ready. He pays upfront an option premium of 4 cents per pound (4 cents X 15,000 pounds=$600).
Buying the put option will give the orange farmer the right, but not the obligation, to take a short position in one orange juice futures contract at the predetermined price of 135 cents at the time of option expiry. This futures contract will give him the right to sell the oranges at this predetermined price (135 cents/pound X 15,000 pounds=$20,2500).
Orange Juice Put Option Calculations at Expiration
- If the price of orange juice declines to 110 cents per pound, the long orange juice put option will come in-the-money. This means that the strike price is higher than the market price and therefore the option is worth money. The farmer will exercise the option. The farmer will get the short futures position at 135 cents. He will gain 25 cents/pound from the futures position (135 cents/pound – 110 cents/pound = 25 cents/pound). He paid the upfront option premium of 4 cents/pound taking his net profit to 21 cents per pound. He can sell his orange juice at the market price of 110 cents, taking the total sale price to 110 + 21 = 131 cents/pound. For a 15,000 pounds contract, he will receive 15,000 * 131 cents = $19,650.
- If the price of orange juice stays around the same levels (say at 133 cents) at the time of expiry, the option will get exercised. He will get the short futures contract at 135 cents and can square it off at 133 cents, giving him a profit of 2 cents. He will sell his orange crop at market rates of 133 cents. Deducting the 4 cents he paid as option premium, his net sale price is 131 cents/pound (133 + 2 - 4 = 131 cents/pound). For a 15,000 pounds contract, he will receive $19,650.
- If the price of orange juice rises to say 150 cents at the time of expiry, the option will expire worthless (as the current price is higher than strike price of the put option). The farmer will not be able to exercise the option and will not get the short futures contract. However, he will be able to sell the orange crop at market rates of 150 cents per pound. Deducting the 4 cents he paid as option premium, his net sale price will be 146 cents/pound (better than his expected level of 130 cents/pound). For a 15,000 pounds contract, he will receive $21,900.
In all the possible scenarios, using a put option of orange juice contracts has provided the farmer dual benefits. His risk is limited on the downside with a guarantee of minimum price level (131 cents), plus he is able to benefit from the upward price moves. This comes at the cost of the option premium of 4 cents/pound.
On the other side, let us consider an orange juice processor who must buy one unit of frozen concentrated orange juice in six months. The current price of one unit of FCOJ is 135 cents. The processor is concerned that orange prices may rise, so he wants to limit his purchase price to a maximum of about 140 cents/pound. To gain price protection, the processor can buy one orange juice call option. She selects an option with strike price of 135 cents and expiry date of six months in the future. The upfront option premium cost is 4.5 cents per pound (4.5 cents X 15,000 pounds = $675). At the time of expiry, this call option, if in-the-money, will give her the right to take a long orange juice futures position which she can square off at existing market rates to lock the buy price.
Orange Juice Call Option Calculations at Expiration:
- If the price of orange juice declines to 110 cents at the time of expiry, the option will expire worthless (as the current price is lower than strike price of call option). The buyer will not be able to exercise the option and will not get the long futures contract. However, she will be able to buy the oranges at the market rate of 110 cents per pound. Adding the 4.5 cents per pound she paid as the call option premium, her net buy price will be 114.5 cents per/pound (better than his expected level of 140 cents/pound). His net cost will be 114.5 cents * 15,000 pounds = $17,175.
- If the price of orange juice stays around the same levels (say at 137 cents/pound) at the time of expiry, the option will get exercised (as the current price is higher than strike price of the call option). The orange juice maker will get the long futures contract at a predetermined 135 cents and can square it off at 137 cents, giving her a profit of 2 cents/pound. She will buy her oranges at market rates of 137 cents. Deducting the 4.5 cents she paid as option premium, the net buy price is 134.5 cents/pound (137 + 2 - 4.5 = 134.5 cents). His net cost will be 134.5 cents * 15,000 pounds = $20,175.
- If the price of orange juice increases to say 150 cents/pound, the long orange juice call option will come in-the-money and will be exercised. The buyer will get the long futures position at 135 cents. She can square it off at the converging price of 150 cents, as gaining (150 – 135) = 15 cents from the futures position. She paid the upfront option premium of 4.5 cents taking net profit to 10.5 cents/pound. She can buy oranges at the market price of 150 cents, taking the total buy price to 139.5 cents/pound (150 – 10.5 = 139.5 cents/pound). His net cost will be 139.5 cents * 15,000 pounds = $20,925.
In this case as well, using orange juice options guarantees a maximum capped buy price in all scenarios, with the benefit of lower buy price in case of market price declines. By paying a fraction of the cost in the form of an option premium, the producer and consumer can effectively protect the downside risk and yet keep the upward profit/saving potential high.
Apart from hedging scenarios, traders actively make speculative bets on orange juice contracts to benefit from price changes and arbitrage opportunities. Marketmakers also make an important contribution by offering sufficient liquidity and tight spreads in the options market.
How Are Orange Juice Options Different from Futures?
Ideally, either futures or options can be used for hedging, speculation, or arbitrage. However, a clear advantage long options have over futures is that long option positions don’t need margin money or a daily mark-to-market like futures. This convenience comes at the cost of nonrefundable option premium being paid upfront and is prone to time decay. Short options do require margin capital.
Long options also limit the losses (capped to option premium paid), while futures have unlimited loss potential on both long and short positions.
Market Profile and Participants of Orange Juice Options Trading
Futures trading in frozen concentrated orange juice started in 1945 and is claimed to be one of the reasons for oranges taking one of the top spots in U.S. crops. Currently, frozen concentrated orange juice futures contracts trade on the ICE exchange. The physical settlement of one contract equal to 15,000 pounds of orange solids is done through delivery in drums or tanks. Allowed countries of origin for oranges are the United States, Brazil, Costa Rica, and Mexico.
Brazil tops the orange-producing nations list followed by the United States. These two countries are the most influential markets for determining international orange prices. Around 98 percent of U.S. oranges come from Florida, where the crop is susceptible to extreme weather events like hurricanes or unexpected cold snaps that can wipe out the entire season’s crop. The concentration of most of the crop in a single location and the possibilities of extreme weather events, as well as similar conditions in Brazil, have led to high uncertainty and hence high volatility in orange prices. This volatility is reflected in orange options valuations.
Here is the volatility graph as available from ICE exchange report (Source: CRB-Infotech):
Such varying volatility leads to high volatility skew, which makes orange juice option contracts suitable to trade ratio spreads. Ratio spreads using options fits those instruments which have high volatility skew (i.e., high levels of variations in volatility between ITM, ATM and OTM options).
The ICE Exchange has FCOJ A options available for trading across the cities of New York, London and Singapore, ideally covering all geographical locations across APAC, Europe, and the United States during the 24-hour cycle.
Factors impacting orange price and orange option valuations:
Any agricultural commodity is affected by weather and disease. Oranges are no exception. In fact, the majority of oranges for orange juice are grown in two locations, Florida and Brazil. This means that an extreme weather or disease event in one location can disturb or even destroy a huge amount of global FCOJ supply. Both countries are impacted by hurricanes and unseasonable freezing and frosts. Brazil also suffers from droughts from May to June which can affect the orange crop. These weather events impact the orange crop, which impacts FCOJ prices and options prices.
Orange juice options traders must pay close attention to seasons and weather forecasts. Hurricane forecasts can result in steep price rises as traders anticipate damage to the orange crop. Once the hurricane passes, prices will adjust to reflect the actual damage suffered by the crop. In anticipation of the winter freeze damaging the orange crop and reducing supply, prices often go up in November. This price spike can reverse in December and January once the extent of freeze damage becomes clear. The ICE exchange report (Source: CRB-Infotech) provides the following illustration:
Traders should also be aware of how changes in consumption habits can affect orange juice prices. An increase in consumption in the country where the oranges are grown could reduce the export supply. Consumers could stop viewing orange juice as a health drink and move on to other beverages, as has been happening in the United States. The reduction in consumption can lead to price declines.
Government policies, local labor laws, and international trade developments can impact orange production and supply. The orange and orange juice demand and supply report from U.S. Department of Agriculture covers estimates across all orange-producing regions in the United States and abroad. Orange juice options traders should also follow related news items specific to orange juice trading from popular market and news data providers like Bloomberg.
To trade orange juice options, one needs a commodity trading account with regulated brokers who have authorized membership with the respective exchange.
The Bottom Line
Interest as well as diversification requirements have led to traders looking beyond the ordinary security classes of equities, bonds, and plain-vanilla commodities. Orange juice has been a highly volatile soft commodity in recent years, making it a high-risk trading asset. Apart from the above listed factors which affect the orange spot prices, orange juice option trading is also impacted by factors specific to option pricing models - exercise or strike price, time to expiry, risk free rate of return (interest rate), and volatility. Orange juice option traders should be aware of these dependencies. Trading orange juice options is advisable only for experienced traders who have sufficient knowledge in options trading.