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.