Coffee futures have tanked. It’s been two weeks since the last post in which I warned against the dreaded June seasonal and advised you to take profits or tighten stop losses. That was a blink and 20 cents ago, the same day in fact that prices peaked. Coffee has a reputation for eating like a bird and (cover your ears children) shitting like an elephant and it’s living up to its reputation. Whenever you feel confident in this market, you ought to consider getting the hell out. Those of you who trade coffee futures have a distinct advantage over me, who for whatever ungodly reason insists on trading futures options.

The advantage of trading futures options over futures trading alone is the ability to stay in a market without risking more than 100 percent of the margin or purchase price. The downside to being long coffee futures options is that you can really only sell when prices are on the rise. When prices are falling and you have a contract with some decent equity in it, the chances are slim you’ll sell on a slide. This is because your ask price, if not at market, will wind up being above the market as prices decline and you’ll be locked into your contract.

One way around this, and my general method of long term trading, is once there is sufficient equity or the call option is sufficiently in-the-money, you can actually convert your option into a futures contract, and then trade it as such. This gives you the best of both worlds; an initial entry with staying power, and later, the ability to follow the market with a stop loss to reduce your risk. But this only makes sense with deep in the money options, because you don’t want to lose time value in the conversion.

Anyway, after 3 attempts to take profits and sell my options on the way down, I’m pretty much locked in to my coffee futures options position, which is presently long out to September. This brings me to my second point, which is that when looking at futures prices on a long term basis, it’s probably time to buy again. It feels like there’s blood in the streets. And if you weren’t wise enough, or rather, if you’re as unwise as me, than you’ve ridden prices down 20 cents and are sweating this drop. This is usually when people throw in the towel and kick themselves. It’s also when the smart money buys your contracts for cheap.

If you take a look at the chart, prices have declined to the long term trend line which connects lows at the beginning of March to the middle of May to the present. A trend line in a bull market is simply a line connecting the successive higher price lows or dips. No other technical indicators are flashing a buy at present, and won’t for some time. The 8, 18, and 40 day moving averages have all been breached, and the MACD, which flashed a clear sell signal two weeks ago is working through a deep valley. But one of the most important indicators from my experiences is when prices sell off hard and come to rest on the trend line. It’s simple, straightforward, and for whatever reason, it works more often than not.

Despite this, we’re still looking at a strong mix of signals. Coffee futures are in a nose dive and have no immediate technical support. Coffee seasonality dictates that for the next month prices should remain weak if not continue this landslide. And on top of that, news is coming out that Brazil may be having a larger than expected harvest, which should provide ample supply to carry us through to next years harvest. All that said, the news is worthless and one must set their own trading rules, and let prices tell them where they’re going, rather than insist the market capitulate to their own fancy. I’m siding with the commercial indicator from several months prior and the current long term bull structure to the market.

In the back of my head I’m still curious why commercial interest in coffee was so heavily long just a couple months ago. As we discussed in Commitment of Traders and Coffee Futures Coffee futures have shown us their typical 40 to 70 cent rise following such an indicator, but I can’t help but feel we haven’t seen the end. This sharp decline should correct the rapidly expanding open interest and allow for fresh buying power to enter the market. In short, Coffee futures may stagnate for another few weeks, but it sure looks like this price zone is a good buying opportunity for the long term. If prices continue to fall and breach this trend line, that will contradict my forecast and we should put this market on hold for a while. But I expect commercial buying to pick up on this correction, and the coffee futures market to gain a fresh footing.

This is a chance to enter this market with little risk, as you can place a tight stop loss just below the trend line. But don’t dive in heavy just yet as coffee futures prices may have a pillow on them until this seasonal fizzles out a month from now. So if trading futures, go light with a tight stop loss, and if long call options, buy yourself a lot of time. I’d consider December at the money calls at this point, as Coffee futures may be a bit testy in the short term.

The previous post on breakouts and failed signals discussed the significance of futures price breakouts from long term trading ranges. In terms of coffee futures, this suggested a powerful bull run to come. That post also discussed the relevance of consistently accurate indicators giving a false signal. Both of these events occurred in coffee futures just 3 weeks ago, and since then coffee futures have made a run up to $1.43 as of today.

And now we are left in a very curious situation. Coffee futures, like most other commodities have natural production and consumption cycles year on year known as seasonality, or the tendency for futures prices to rise and fall at certain times of the year. Coffee futures have the single strongest seasonal tendency of all commodities in June and July, and it doesn’t work in our favor. The tendency is for coffee prices to crash. And I do mean crash, and not simply correct. The chart below is a seasonal chart of coffee futures.

In the last 30 years there may have only been 2 occasions where coffee futures prices have not ended lower by the end of June than they were the end of May, and it is typical for them to end significantly lower. This consistency in price collapse is a result of the onset of the Brazilian harvest in May and June, as Brazil is the largest producer of Arabica coffee. This force is usually strong enough, even in times of tight supply and demand, to force a corrective downward adjustment in prices. And the question on everyone’s mind is, “Are we going to experience the same this year.”

There are occasions in commodity trading of course where prices reject their seasonal tendency. When this occurs it’s usually as sign of very strong underlying fundamentals, and you’d be well advised to go with the flow. This is a similar concept to the Hounds of the Baskervilles concept discussed in the previous post. When something ought to occur and it doesn’t, that in itself is an important indicator and perhaps even more significant than your average futures price indicators as it implies the strength of forces that are, at least at present, imperceptible and dominant.

Coffee futures were coming dangerously close to flashing bearish divergence on several indicators, but after today’s strong move up, that has changed. I was hoping for a clear sign of bearishness, as that would have ceiled the deal for siding with the bears short term. Indicators would have corroborated the seasonal tendency for prices to fall. But that is not happening, which leaves us in a very precarious situation. The seasonal tendency is for coffee futures prices to fall, the current trend is clearly up and gaining momentum, with no technical sign of waning.

This market has absolutely everything going for it at the moment, with the exception of the typical seasonal downturn. Coffee fundamentals are incredibly bullish, with Columbian price differentials somewhere between 70 and 90 cents above the futures price. This is a record and when similar things happened in the past it’s resulted in higher futures prices. Columbia, Vietnam, and Brazil are all looking at smaller crops this year, and it will be a year before producers will have a chance of alleviating tightness. Prices have broken out of a five month range while simultaneously breaching the 1 year downward trend line.

Despite this overwhelming case to be long the market, prices are feeling toppy, at least short term. Those of you who have been with me for a few months are in this market from $1.15 and have already made 300% profit (based on margin requirements) per futures contract. This is a $10,000 profit with an initial risk of $1,000. If you’ve purchased long dated options then your profit is less, but still somewhere in the 200 to 300% range. And while I’m not suggesting you bail out on the bull, it is time to tighten stop losses on futures and to take a little profit on options holdings. After a correction we may consider reentering in full and adding to the position. So in sum, let the bull ride, but be cautiously optimistic. This seasonal tendency can come out of nowhere with great force.