As coffee prices have been rising over the last few months, we have been keeping an eye out for a trading opportunity. As usual, once prices really started to ramp, the financial press caught on and started running stories about the big coffee companies – Starbucks (SBUX), Green Mountain Coffee Roasters (GMCR), Coffee Holding Co. (JVA), etc. – and how they will be affected by rising prices. What the average investor may not understand (or the average financial writer) is that a commodity’s price and a commodity stock are not always positively or negatively correlated like you might expect.

How It’s Supposed to Work

For example, you might assume that Starbucks or GMCR would be exposed to the higher cost of inputs as coffee bean prices rise, which would hurt their bottom line. Theoretically, that would be true because there is a lag between the time the price of inputs increase and a company can raise prices on its customers. In fact, that lag tends to be so long that most price spikes are over when retail prices finally respond.

You might also assume that coffee producers and brokers will be more profitable as coffee prices rise. Assuming costs don’t also go up, rising prices for beans should help distributors because they have much less lag between the time their cost of production and acquisition increases; thus, they can increase the price on their buyers (retail coffee companies, supermarkets, etc.). However, in reality, this theory breaks down because of hedging activity.

If Starbucks wants to prevent higher coffee prices from hurting its bottom line, it can buy futures contracts for coffee. As prices rise, the value of those futures or forwards will also rise and offset potential losses. Similarly, producers and distributors can sell futures contracts to lock in prices today while beans are expensive. If coffee prices top out, a distributor who has sold futures contracts will profit and it will offset their losses, and potentially enhance their profitability.

Meanwhile in the Real World …

If retail firms could buy futures at the bottom and then sell them or accept delivery at the top of the trend, it would be great. Alas, in the long run, hedging helps smooth volatility for these firms but it does so at a very large economic cost. Starbucks, GMCR, JVA, et al. have no better ability to forecast the price of coffee beans in the future than anyone else. That is not just our opinion; their own public track records show that they are really bad at timing their trades.

Assume that there is a fictional coffee company called “Java John’s” that is currently buying futures contracts to hedge its exposure to price fluctuations. Pretend that Java John’s controls 50% of the market for retail coffee purchases and there is another company called “Dan’s Burned Beans” that controls the other 50% of the market.

Dan’s decides not to hedge and take the risk that coffee prices are going to fall. If Dan’s management team is correct (or just lucky), then all of the sudden, they have a significant pricing advantage over poor John’s. They now have a lower cost of inputs because they didn’t hedge and can undercut John’s prices or keep their prices the same and make more profits.

The point is that hedging is a zero sum game. There may be some benefits, but sudden price spikes are prone to create an over-reaction that will likely give some company like Dan’s an advantage.

Unfortunately, sentiment in the coffee market has been extremely fearful as the drought in Brazil got worse this year. Buyers and sellers have been extremely active and open interest in these contracts is very high. I have not seen volume in these contracts like this at any time over the last decade despite the 2005, 2008, and 2011 coffee price spikes.

Most companies with exposure to coffee prices, such as Starbucks, have been extremely active in the futures market. So much so that it is very difficult to tell whether any of these firms will have a relative advantage over the others if prices rise again or fall in the short term.

Selling a Hot Market May Be the Best Opportunity

However, we think there is a very interesting opportunity to profit from coffee prices right now because of the hyperactive trading and hedging. Despite weather reports, no one really knows whether coffee prices are going to continue to rise or fall. However, we know from history that it’s more typical for a hot market like this to crash much harder than it is likely to rise once it starts to form reversal signals.

Currently coffee futures are forming a massive bearish divergence as volume declines and traders in the futures market shift from a net long to an overall net short position. These three factors have been very predictive in the past. We could only find one example of these circumstances lining up and coffee prices rising still higher over the last 15 years and that was in 2010. However, when those same factors lined up again in 2011, coffee prices dropped 50%.

ICE Coffee Futures w/ Bearish Divergence – Chart Source: MetaStock Professional

Of course, shorting or buying puts on coffee futures may be the most direct route to profit from an expected decline in coffee prices but it might not be possible for everyone to access those markets. Indirectly, we would expect the iPath DJ Coffee Trust ETN (JO) to track pretty close to coffee futures prices, since that is what it is indexed to. Volume on the chain sheet is a little thin but could still provide an opportunity for a risk tolerant investor.

Alternatively, traders could take advantage of coffee related firms who tend to drop fast when coffee prices drop. Coffee Holding (JVA) is an example of this kind of company whose poor fundamentals make them extra sensitive to price changes. The last time the price of coffee dropped after a spike, JVA moved from $30 per share to $7. That was a bit of an anomaly but management still warns shareholders that a fast decline in coffee prices will be bad for the firm.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.

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