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.

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.

Before I get into the many reasons Coffee Futures are the single Best Investment in Commodity Trading for 2009, let me begin by saying that futures trading is not easy.  Below I give you the why, not the how, to own coffee in the coming year.  In follow up posts I’ll talk to more specific strategies, including coffee futures trading, coffee options investing, and commodity etfs that a novice can use to invest without risking the farm…or in this case, the plantation.  On to the Glory.

I am not a waffler or your typical investment news reporter.  You know the type with their half hearted price projections and potentialities.  These jokers flood the news with crap like “Coffee futures could rise 15% in 2009 due to supply problems” or “The best investment for 2009 may very well turn out to be coffee.”  If you’re anything like me than you hate this garbage.  It elicits an immediate emotional response…hope, greed, without containing any real substance.  Well let’s discuss the matter like courageous adults or confident gamblers shall we and put your money where my mouth is.  Coffee futures are going to record highs before December 2010, and people will look back on January 2009 prices as being dirt cheap.  Mark the time of this posting, the end of January 09, with futures prices around $1.20, as the beginning of the largest bull market coffee has ever seen.

Coffee has a unique story to tell.  While virtually every other commodity is experiencing a moderate to sharp cutback in demand due to the global financial and now economic crisis, coffee has been one of the few beneficiaries of gloom.  Fortunately for coffee producers, and even more fortunate for coffee futures traders, coffee consumption rises when the world is stressed out, depressed, and nervous.  Coffee consumers cutback on their Starbucks frapolates and start buying Maxwell House for a morning cup of joe at home.  This is bad for Starbucks, but good for coffee futures prices. 

I don’t know about you, but when I make coffee in the morning I make a mess.  And judging by historic at home use patterns, more coffee is consumed, wasted, and dumped down the drain due to the inefficiencies of at home brewing.  But is this enough to make coffee futures the single best investment in commodity trading this year?  Not by itself, no.  Coffee demand has been on a constant rise every year for nearly two decades.  And so has supply for that matter.  The caveat here, however, is that coffee production has not kept pace with consumption, and we’re facing at present a perfect storm for coffee futures prices.

Before we tackle the reasons for coffee’s imminent rise, let’s quickly look at some of the long term factors contributing to this coffee crisis.  Coffee, like every other commodity since 2001, is experiencing rising demand due to the rapid growth of China and India.  I currently live in Shanghai and I can tell you first hand the rate at which the Chinese are embracing coffee culture in what has traditionally been a nation of tea drinkers is astounding.  Even in every second and third tier city in China you’ll have no trouble finding a decent cup of joe.  On top of that, consumption in producing nations like Brazil, Vietnam, and Columbia, the three largest producers of the commodity, have made great progress in augmenting local demand.

On the production side we have a few key factors converging.  Coffee is a cyclical crop.  Every other year leading producers turn out massive crops which have set world records consistently for many years now.  And every other year coffee trees produce smaller crops while they rejuvenate, having exhausted themselves the previous season.  We are currently at the half way point between the larger production cycle of 2008-2009 and are entering the cyclically smaller harvest cycle of the 2009-2010 season, which kicks off in Brazil around June, give or take. 

Normally the smaller of these production cycles would force producers to draw from stocks (reserves) created during the larger seasons to meet demand, in full knowledge the following season would replace, if not add to, present stock levels.  But the rate of change in demand has exceeded the rate of growth for supply for many years now, and producers have been selling from reserves into gradually rising prices to both meet world demand and to bank a little extra coin. 

What makes this situation dire is the degree to which stocks have dwindled, and more importantly, dwindled in respect to world consumption.  Let’s look at a few numbers here from the International Coffee Organization borrowed from Daily Futures .com:

What should be clear from the above is that for the last 7 years coffee stocks in both on and off years have been at lower levels than their prior biennial ending stock number despite the fact that production numbers have risen significantly.  Furthermore, the stocks to usage ratio, currently at 13% for 2009, is sure to be much lower in 2010, as soon as what at present looks to be an impending shortage to the tune of 10 million bags for the coming season is factored in.  Even without this impending 10 million bag deficit, a stocks (in producing countries) to usage ratio of 13% is the second lowest on record.  What will a loss of 10 million bags do to that ratio?

Now add to this tight fundamental situation the impact of the global financial crisis.  In November coffee futures fell with the herd, the proverbial throwing the baby out with the bathwater if you will.  In a better year the coming shortage of coffee would have begun the pricing in process already.  But money was pulled from everything, stocks, commodities, real estate, in an all out panic.  This pulled coffee from its comfortable range in the $1.40’s down to a low of $1.02. 

The impact this is having on farmers is an inability to secure loans to carry stock forward.  They sold into the declines and pushed prices further along with all the hedge fund managers who were crapping themselves.  In conjunction with this fire sale in coffee, and everything else, fertilizer costs are and have been through the roof, and crop care in producing countries has slipped considerably.  The combination of a lack of funding to hold back product, and a lack of funding to take care of crops is turning out to be the straw that broke the camel’s back.  This market is ready to pop.  Why now you ask?  Perhaps the economic situation is more poignant than I’m willing to admit?  I’m glad you asked.

As I mentioned earlier, in a normal year, a production deficit would be priced in in advance of the smaller harvest.  Coffee futures prices are seasonally driven, typically rising from October through May, crashing in June, and bottoming in July or August.  We saw this phenomenon clearly in 2004 when prices rose from around 70 cents in October to around $1.40 by March of 2005.  And again last year we saw prices bottom in July of 2007, rise gradually through the end of the year, and explode in February to a high of around $1.70.  We are finally through the worst of the financial crisis. 

Coffee is starting to behave more independently.  And we are through the peak of the Vietnamese and Columbian harvests.  But due to a smaller crop out of Vietnam, and a much smaller out of Columbia, the coffee pipeline is beginning to show extreme tightness and delays are occurring in Central and Aouth America.  And as the indelible law of supply and demand dictates, when you have more demand than exists supply, prices must rise until a new supply and demand equilibrium is found.  How high is that you ask?

Jim Rogers, that infamous commodities investor has said that during a commodities bull run, every commodity reaches a new all time high.  We have seen that already in gold, crude oil, soybeans, corn, wheat, copper, platinum, lead, and several others.  Crude, Corn, and Wheat, having had some of the tightest supply and demand fundamentals did not merely reach new highs; they destroyed previous records to the tune of 100 to 300%. 

Coffee has a very similar fundamental setup to that of Corn from 2005 before it quadrupled in price.  Look for Coffee to climb well above its historic high in the $3.50 range into uncharted territory.  And look for it to do so before December of 2010.  That’s a 300% rise.  And that’s a ton of profits for anyone in the futures or options game.  Good trading to you and let’s bank this one together.  Stay tuned for updates and trading strategies for coffee futures, the single best investment in commodity trading!