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.

Seasonality in my opinion is one of the most overlooked and important factors in commodity trading in general, and coffee futures trading in particular. Seasonality is the tendency for a commodity to rise or fall at a certain time of year, every year. In many commodities like cotton, wheat, cocoa, and cattle, this manifests in rising prices after the peak in harvest, and falling prices in anticipation of harvest. In other words, seasonality in most agricultural commodities is supply driven.

In other commodities like crude oil and gold, where supply tends to be relatively steady, barring any natural disasters, seasonality is demand driven. Crude oil futures rise from March through May in anticipation of the summer driving season, and again from July through September in anticipation of the winter heating season. If a trader is familiar with these seasonal tendencies alone, and has an intelligent money management system for reducing risk and maximizing gains, I believe trading on seasonality alone is enough make a fortune in commodity trading.

How does this apply to our best investment pick for 2009; coffee futures? Coffee futures prices are heavily influenced by seasonality. There are a few major coffee producers and those few make up the great majority of coffee supply. Naturally, coffee futures prices are very sensitive to the production cycles of these producing nations. Brazil, the largest producer, harvests coffee in the summer months, starting in May or June and lasting through August. In anticipation of the massive contribution to the supply chain, prices drop sharply nearly every June. This is one of the strongest seasonal tendencies in all commodity trading.

There have been only a few exceptions in the last thirty years. So if you’re long coffee futures in May tighten your stops and reduce your position. Coffee prices may also experience declines in September or October before the Vietnamese harvest begins. A great many of my losses could have been avoided if I had taken heed of seasonality, rather than focusing on the fundamentals and technicals of a market alone. So if coffee prices tend to fall under the burden of heavy supply two times a year, when do they tend to rise?

If you’re planning to go long coffee futures and want the support of seasonality, you’ll want to enter in October and look to tighten stop losses in December, and again enter in February looking to tighten stops sometime between March and the end of May. To add weight to seasonality, every major Bull Run in coffee futures prices in the last 30 years occurred between October and May of the following year. Every major Bull Run! During years of large crop production which transitioned to years of much smaller supply, like the year we are currently in, prices had a hard time breaking north before February due to the weight of copious supply from the previous on-year harvest.

When the brunt of this supply began to thin, as it already has already this year, and there is no fresh supply until June, then coffee futures prices can respond with unfathomable strength. In sum, seasonality in conjunction with extremely tight fundamentals and dirt cheap prices is suggesting that coffee futures prices are due to pop. It is mid February, supplies are tight, prices are cheap, and no more coffee is coming online prior to June, when an inadequate and cyclically smaller crop will be harvested in Brazil. Seasonality is one of the many factors supporting my view that coffee futures are the ‘best investment in commodity trading for 2009′.