The second major consideration is that coffee futures look weak as hell.  They broke the intermediate term upward trendline, implying a change of trend.  And they broke support more than once.  This is pretty severe considering the abundance of bullish news out there and the time of year.  So we need to ask ourselves, if this market is in fact in a dire situation fundamentally, why are prices so weak?  Why were coffee futures unable to remain in the previous range in the $1.40’s? 

In the previous post Commodity Investment Strategies to Supplement Your Coffee Futures Trading, I discussed long term strategies for profiting from the coming coffee futures bull market.  But that won’t help too many of you that are trying to make money in the next couple of months, and likewise, looking to retain equity in the next few months despite unexpected corrections.  So let’s examine a few short term strategies for coffee futures trading.

Looking at this coffee futures chart, we can see that coffee has fallen to the $1.30 range, and it seems to be turning up.  Based on the fact that the MACD Histogram is turning up and showing bullish divergence, and the fact that coffee is in a seasonally bullish time frame, it’d be smart not to be short at present.  One of the best ways to play is covered in the last post under ‘writing options’.  In this case, you’d be wise to sell puts, as coffee futures ought to at least have support at these levels.

For futures traders, there are two strategies I’d recommend for coffee futures trading.  The first is simple, go long at the market and place a 5 cent stop loss.  It’s rare to get bullish divergence and seasonality to line up, all at levels that previously acted as strong support.  We’re less than 5 cents from the lows, so this is a pretty safe entry point to give this market a shot.  The other coffee futures trading strategy I’d recommend would be to place a buy-stop above the previous highs at $1.50 and simply wait.  If this market is going to go, it’ll need to breach that resistance level.  If it breaches that resistance, it ought to have the momentum to carry on in a meaningful way.

My approach here, which admittedly is a bit unorthodox, is to buy in-the-money calls for May or July.  This is a strict no no for most options traders, but I couldn’t care less.  When you find a market that has real potential for a run, you don’t want to get shaken out.  A call option will allow me to ride out further corrections without losing my position.  I’ll be able to be in the market immediately, and won’t have to wait for a breakout. 

If coffee futures run up 30 to 40 cents, I’ll convert my call option to the underlying contract, and be long 1 futures.  At this point I’ll follow the market up with a stop loss.  If at that time I suspect further gains, I’ll pyramid the position and add 1 coffee futures contract for every 3 I own at that time using the equity gained from the previous move.  This is a combination of an options investing strategy and a coffee futures trading strategy that seems to offer the best of both worlds.

The Problem with Futures Trading
First, let’s make sure we’re on the same page when it comes to futures trading. I explain what futures are at length in Futures Trading for Beginners.  Futures, due to the incredible leverage, which acts as a double edged sword, makes them impractical investment vehicles for we sub-millionaires. What I mean by this is that to play the futures game, you must be a trader. You need to be focused on limiting losses and maximizing gains on every trade, all the while playing trade probabilities based on historical price movements and chart patterns. This requires dedication and constant attention. And you will lose at least some of the time.

Most futures traders have more than $50,000 dollars of equity to risk, and they tend not to risk more than 2% of their capital on any one trade. Talk about grinding it out. Nevertheless, because of the great leverage in futures trading, one can wait for a safe entry point, risk little, and potentially walk away with 3 or 4 winners that outweigh 10 losses. A good trader will be right somewhere between 40 and 60 percent of the time. This is why gamblers make better traders than surgeons or lawyers. A 60% success rate for a surgeon means 40 % of his patients have kicked the bucket under his knife. That doesn’t look too good. But if you shoot for perfection in futures trading (with a rare few exceptions out there), you will lose all very quickly.

But I digress. My purpose here is to discuss alternative investment strategies for one to profit from the impending Bull Run in coffee futures, applicable of course to long term bull runs in other commodity markets. As such, futures trading should be seen as a very short term approach, lasting minutes to a few days. But many of us believe the big money is in the trend, and this can last weeks to months to years. Unless you have millions and millions in your account, you will not be able to wait out a move like that in coffee futures without experiencing painful corrections that could wipe you out. So let’s look at a few alternatives for the long term investor that will limit risk while allowing them to stay the course.

Futures Options Investing
Most traders/investors do not ‘invest’ in futures options. Traders like them because they offer an edge in terms of probabilities. Sophisticated traders track risk quantifications and look to sell low risk options to traders who are full of hope or who are looking to hedge. For a more simplistic explanation of what futures options are, please read Commodity Futures and Futures Options.

Options trading does not need to be as complex as some make it out to be. If you were not looking to take advantage of risk imbalances or short term mathematical anomalies in the market, but merely to profit from a long term move in a commodity, options can provide a long term investment vehicle for holding tight through peaks and valleys.

At-the-money futures options that have about 4 months before expiration generally cost as much as a margin requirement on a futures contract. The entire value of the contract is time, as an at-the-money option has no inherent equity. This is generally too little time and too much money to risk on a contract that needs to rise considerably just for the investment to break even. If you believe your bull move will happen within 6 months to a year, you should try to purchase an option with a year to a year and a half of time before expiration. And you should look to purchase equity with that option as well as time.

Coffee futures right now are about $1.40. Let’s say a December $1.40 call option costs $5,000 and a December $1.30 call option costs $6,500 dollars (these are not today’s prices, I’m over simplifying). If you purchased the $1.40 call, you’d be buy 10 months of time, and zero equity. This means the market would need to rise 15 cents, just for you to break even. If you purchase the $1.30 call option however, you are buying 10 cents worth of equity, or $3,750 dollars worth. This means that you are only paying $2,750 for the time left on the contract. And while your maximum loss could still be 100% if the market collapses, when taking a longer term approach, buying in-the-money options adds a considerable cushion to the investment. The market would need to rise 7 or 8 cents for you to break even, and if it remains flat, your risk is half of what the at-the-money option offers.

But this has another, often unspoken benefit. Let’s assume that I’m confident about coffee making a run, which I am. For me to buy coffee futures and comfortably wait 10 months, I’d want to have at least 15 to 20 cents of safety to be sure I could hold out for that amount of time. This means that if I want to be long for 10 months, I should be able to risk 20 cents. If the contract costs $3,500, then that means I am going to risk 200% of my initial margin, which is a pretty terrible entry risk considering the market could correct that much, stop me out, and then recover leaving me at a huge loss without a position anymore. I can instead purchase an in-the-money call option, limit my total risk to $6,500, and wait out the market until it proves or disproves my suspicions.

That’s on the downside. Let’s assume coffee futures make a real run for it and shoot up 50 cents over the next month. I have the ability to exchange my option for the underlying futures contract. Now, if this was a risky thing in the first place, why would I want to do it now? Well, for two reasons. The first is that a deep in-the-money option is not always easy to sell immediately at your price. The second is because you cannot set a stop loss on an options contract, but you can on a futures contract. So if you own that option and the market falls, you’re going to have a hell of a time getting a decent price for it. If you have a futures contract, you can ensure a certain amount of profits will be retained.

So after you’ve protected yourself from unlimited risk and have been rewarded by selecting the right market, you can convert your contract, set a stop loss, and let the market tell you when it is finished rising. Otherwise you need to sell that option at a price you think makes sense, and that may be well in advance of the market top. But a stop loss allows you to lock in profits while at the same time allowing for further gains. It also allows you to use the equity in your contract to increase your position, or what is called pyramid your position.

Writing Futures Options
For those new to writing futures options please have a quick look at this lesson on Writing Call Options.  Now that we’ve finished talking about long term strategies for buying and holding options, we should talk about the other side of that equation. Just as you can purchase an option, you can also sell, write, or create an option from nothing and sell it to someone else. This, my dear friends, is modern day alchemy. With a bit of study, a bit of risk capital, and some big balls, you can essentially write your own check this way. You are selling hope, the hope that the market will go up or down, to someone looking to profit from either movement. When you write an option, the price of that option is debited to your account. That’s right, you sold an option to buy something that doesn’t exist, and it’s lining your pockets. The downside is that if the market goes their way and not yours, you are accountable for infinite risk. Their profit is your direct loss. Therefore writing options has all of the risk of a buying a futures contract, with none of the rewards.

Let’s stay with our frequent example here and say that you’re still bullish on coffee futures…or rather, not at all bearish. The beauty of writing options is that the market doesn’t have to go away from you to make money; it can also stay flat, or even move toward your strike price as long as it does not cross that price by expiration. Anyway, let’s assume you’re bullish on coffee futures, and futures trading is too risky, and options investing is too pricy. You can write out-of-the-money put options as the price of coffee rises and simply collect on lost hope. Someone else may think coffee is overpriced and want to purchase coffee puts in order to hedge a larger position or to profit from price collapse. You can sell this hope and security to them.

As coffee futures are presently approximately $1.40 and sitting on the long term trend line, the margin of safety here is significant for someone looking to go long. It is more significant for those who are looking to not go short, as you can comfortably write short term (1 to 3 months) out-of-the-money $1.30 puts and wait until they expire worthless. This can be done over and over again, forever. And as coffee futures rise, as we suspect they will, you can continue selling insurance for those who are long the market. It’s steady money, but it isn’t without risk. And I implore you; do not sell puts in June for this market, as coffee has a vicious seasonal downswing every year. That may be a good time to reverse your position and write call options to those expecting further price climb.

Investing in Commodity ETF’s
Well, this was the section I had in mind when I sat down to write this post. As usual I got carried away. Let’s leave aside the possibility of leveraged ETF’s, which do exist, and simply talk about regular Exchange Traded Funds. For those lacking the time, knowledge, or money to utilize the options above, you don’t have to fear missing coffee futures rise to the highest prices in 10 years. There are commodity ETF’s which track commodities, eliminating much of the risk (and much of the reward) inherent in futures trading.

Trading an ETF is akin to trading a stock or a commodity, which is not the subject of this post. Investing in an ETF on the other hand can offer some of the unique commodity trading advantages while eliminating some of the futures trading risks. A coffee ETF will rise and fall in coordination with coffee futures prices. But removing that dangerous leverage allows you to trade as you would a stock, where rock bottom is zero, rather than risking infinite losses. You can remain long coffee as long as you like this way, without concern for sharp corrections or concern for coffee being delivered to your doorstep because you didn’t sell prior to contract settlement.

There is one major advantage to trading a commodity ETF, and that is ability to use the COT report. In long Term Coffee Trading and the COT Report I discuss how this insight to insider trading is a tremendous edge for the long term trader. The problem with it is it foretells moves well in advance, and remaining in a market long enough without being stopped or shaken out is quite challenging. Well with ETF’s that isn’t a problem. You can wait patiently until commercial traders are buying in droves and then step in to get you some. This will have you in the market before markup phases or volatile trade occurs. You’ll be early and in at rock bottom prices.

As prices start to raise you can place stop losses at long term trend lines or moving averages to ensure or lock in profits. This is a long term trading strategy that may not promise the highest possible return, but it will offer the easiest long term money. One option is the coffee ETF COFF. This ETF is 100% invested in coffee and is a managed account that trades coffee futures. You however do not trade coffee futures, you simply buy and hold the fund. Not a bad setup.

I want you to take a look at the coffee price chart from 2008 before coffee futures ran to the highest prices in 10 years.  Comparing our current setup at our current time of year in 2010 to that in 2008, we’re looking at a nearly identical technical setup.  Prices were range bound for almost 2 months into the end of January.  You’ll notice futures prices bottomed around the 25th of January and from there climbed steadily for 30 days.  What’s more important is that that run up was preceded by bearish divergence on the MACD histogram, which, as I mentioned before, has a strong track record for fortelling major turns in this market.  It was wrong then, which is indicative of exceedingly strong fundamental factors. 

In mid December of 2009 the MACD Histogram flashed bearish divergence and prices corrected down to around $1.35.  If we can see coffee prices hold and/or correct at these current levels in the upper $1.30’s, both the MACD histogram (plotted on bottom) and the Relative Strength Index (plotted with prices on top) will give a strong buy signal, that is, this valley will be shallower than the last for both indicators.  All commodities were adorned in red today thanks to our paradoxically strong dollar, but should that fail to maintain its strength, then coffee futures have a great many bullish influences.

To recap from the previous post, we are in the most bullish time frame of the year for coffee futures.  We are at the longest period of time between major harvests contributed by Brazil and Vietnam, and what would normally provide some alleviation to tightness, Columbia, is experiencing severe losses this year due to weather.  Ice certified stocks are the lowest in 7 years, and the stocks relative to global consumption are the lowest in 30 years.  And…technicals could be turning very bullish here before week end.  It’s time to be long this market, and at these levels one can enter with strong fundamental and technical support.  And if you’re not long, you don’t want to be short.

Columbian coffee cash differentials are approximately 70 cents above the March futures price. This means that those in need of Columbian arabicas are paying $2.00 for a coffee that can be substituted with similar, cheaper product. Historically this situation plays out by dragging futures prices higher as tighter coffees are substituted with cheaper alternatives abroad. This setup is a form of backwardation, though it hasn’t directly manifested in futures prices yet.

Contango, an upward sloping yield curve, is the normal state of a commodity. Storage and shipping adds costs to the current spot price, and causes distant futures prices to exceed near futures prices. This implies a state of ample short term supply. Backwardation, or a downward sloping yield curve, implies the opposite. Backwardation occurs when the nearest futures prices are higher than distant futures prices. For example, if March coffee futures prices exceeded July coffee futures prices, the coffee market would be in backwardation.

Backwardation suggests extreme tightness, and reflects the fact that buyers are willing to pay higher prices to secure immediate product rather than hedge or wait for less expensive contracts. Backwardation is perhaps the most bullish of market signals. Prices are directly telling you there is a supply deficit. That is essentially what we have occurring with Columbian spot price differentials, despite the fact that this tightness has not resulted in futures price backwardation yet. It might soon.

Furthermore, ICE certified coffee stocks are at their lowest since 2003, evidencing consumption has not dwindled through hard times. Taking into account this stocks situation, the Columbian spot differentials, a strong bullish seasonal tendency, and uncertainty over the coming harvest while consumption is on the rise, the situation looks particularly bullish. Coffee futures are clearly in a short, intermediate, and long term bull trend, and prices are a stones throw away from $1.50. If we can see prices exceed and hold above that price, we could see a very fast climb to the previous 2008 high in the $1.75 range.

The one caveat here is that production estimates for the coming Brazil harvest are all over the place and direction of the dollar is questionable. CONAB released an unusually high production estimate, but it doesn’t take into account probable quality issues that may have occurred due to poor weather and a lack of maintenance throughout the financial crisis. And even if they are accurate, we have to wait 4 months before ‘ample’ product starts rolling in. In sum, this market at the very least is being supported by actual supply tightness, and at most is gearing up for a move north.

Coffee futures have been range bound to drifting lower since mid October, but have gained over 15 cents in the last two weeks to challenge the highs set in October. Coffee has a lot going for it fundamentally speaking, but what’s more important is coffee’s seasonal tendency to rise in December, and to maintain an upward bias until March. If coffee is going to make a run this year, we are in that perfect time frame for it.

The decline from October into mid to late November is also consistent with coffee seasonality, and although this may have seemed like weakness in the market, it was probably more of a constructive shake out of weak longs and the last major buying opportunity for commercials. From a longer term perspective, it should be obvious that coffee futures are making higher highs and higher lows, the very definition of a bull trend. This should, until prices prove otherwise, leave the long term investor with a ‘buy the dips’ mentality.

At today’s prices, which are nearing the highs of the year, the short term investor should watch very carefully for further advances. Breaching previous highs at this time of year will leave the 2008 highs in the 170s as the only ceiling for prices in the last 10 years. The best way to trade this market after today’s jump in prices is to set buy stops above 150 which stop you into a long position should coffee futures advance. Because prices have been range bound, a breakout should lead to a new consolidation zone at higher prices which leave the current range safely behind, while providing a low risk entry point.

Sugar and Cocoa futures have both had their fun this year, and now I believe its coffee’s turn. Not to mention that cocoa and sugar are at levels that may be tough to sustain from a fundamental perspective, and when investors start to pull out their cash and take profits, it should drift into the only other soft commodity with bullish fundamentals, coffee. If those two commodities could rally as they did this year with a more subtle bullish case, then coffee should be primed to experience a mark up that parallels them both, doubling prices and taking them into the $2.50 to $3.00 range, for starters.

Timing this market is, has been, and always will be a bitch. But someone with deep pockets and a bit of patience is going to get paid within the next year from this market. If one doesn’t have experience trading, I’d highly recommend buying coffee ETF’s. ETF’s lack the leverage of futures, which both reduces profit potential and reduces risk, but they do allow one to stay the course and see this market do what its been preparing to do for the last 10 years.

For those looking to time this market, you have a window of safety in to March. Option sellers will have a field day selling puts into this market. And coffee futures traders should be able to trade the trend, and stay long the market with stops below the 20 day moving average. Should this market really run away, stops should be raised to follow prices a little more closely, for when coffee shits, its shits like an elephant.

The size of the Brazilian harvest was more than ample, and considering this is an off-year it certainly is cause for concern over the potential size of next year’s on-year crop. The spark which lit the fire under coffee futures prices back in April has fizzled, as Columbian premiums are dropping and the wait for new supply is rapidly decreasing, alleviating concern for deficit.

I usually post with a purpose, to elucidate trading principles in the context of coffee futures trading, or to update fundamental or technical developments. This post is different, but perhaps it can stand as a lesson of its own. The lesson is this; when things which were previous clear to you become blurred, its time to stand aside.

It’s a difficult thing to believe in an impending bull run in coffee futures and to find yourself temporarily in uncertainty, but it happens sometimes. My natural inclination is to persist, and continue to try to work my initial plan as at one time it made perfect sense. My natural inclination is rarely correct. This is why it is of the utmost importance to define your signals, signals which you understand and which show a base of reliability, and only trade on the basis of those signals.

The downside is you are going to miss important events because markets don’t always conform to market indicators. Coffee futures couldn’t care less how I intend to analyze them, nor do the thousands of players involved in making a single trade at a single price. This never seems to change the fact that we all have that ‘lucky’ feeling that tells us the market cares about us, and that it intends to pay us out this month.

Coffee futures and fundamentals are sending mixed messages at present. This is the ideal time for a seasonal low, and that low no doubt was set in July. Seasonality dictates that we ought to see oscillating prices with an upward trend into December. The strength of the upward trend is contingent on crop outlook, dollar value, and investor demand. We aren’t due for another massive Arabica crop for 9 months or so and that generally underpins prices this time of year. This is generally bullish.

Futher bullish signals include COT funds increasing longs, which portends a longer term upward trend, global economic news is improving, global coffee consumption is increasing, and investment demand should return in droves to commodities. Before long inflationary pressures should grip commodities again, at least those which have supportive fundamental conditions, and push them to all time highs. That’s what we’re presently observing in Sugar futures, which are at their highest prices in 30 years despite the fact that fundamentals are fuzzy.

On the negative side, the weight of this year’s Arabica harvest may weigh heavily on coffee futures, as next years harvest is predicted to be massive. If these two crops have the potential to increase global stocks then coffee futures have little hope of rallying significantly. This is very discouraging to someone who just put up a website on the inevitable coffee Bull Run, but we have to adapt. Price may still rally on the basis of seasonality alone, but I’m not finding a clear technical or fundamental picture with which to trade. I’ll stand aside for a short time.

Ways in which to profit from this uncertainty may be to sell out of the money coffee call or put options. Selling these is in essence, selling hope to someone that believes coffee futures prices are going to move sharply up or down. This seems unlikely in the short term, and selling calls or puts may be a promising strategy. I’d be more inclined to sell puts at present, as the coffee futures generally don’t surpass the July lows. We’re not far from the previous lows here, so this lends some safety to the equation. But before selling coffee futures options, make sure you do your own homework. Coffee futures are extremely volatile, and selling hope means you’re also accountable for potential losses.

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.

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.

Trading Breakouts
In futures trading, breakouts are one of the best and most reliable methods of entering a low risk to reward trade. A breakout is what you have when prices step outside of an established trading range. If coffee futures prices oscillate between $1.00 and $1.20 for 5 months, than you have a well established trading range. The high end of a range marks the point at which the bears come out in full force and dominate the trade. The low end of the range marks the point at which bears succumb to the buying power of bulls.

There is nothing intrinsically meaningful about the high and low point of a trading range, but it does mark a point of psychological attachment to gain or loss in the minds of traders. If you were long futures at the top of a range and the market reversed on you, then you won’t be as inclined to make the same mistake again. Those that sold at the top see that same level as an attractive point at which to take profits or short the market as they’re profiting from either.

The natural order of range bound prices is to continue in their indeterminate state. When prices finally break out above or below this range it is cause for careful attention, as previous forces which caused range bound prices has weekend, and a new dominant force has taken control. This force can be very powerful, carrying prices into a nice rally or an extended Bull Run or bear market because those who previously sold the top of the range have just been stopped out or lost big, and those who are long are adding to positions.

Coffee futures have just experienced a breakout on more than one level. A continuous chart of coffee (not shown here), one that plots the highest volume months, would show a price breakout as of last week. If we look at the chart below, we’re within one tenth of a cent of a breakout of the July 09 coffee futures chart with a trading range upper edge around $1.26. On a long term basis last week was a breach of the long term trend line which has been dead on balls accurate since prices peaked in early 2008. A breach of trend line is the best indication of a market reversal. Coincidentally these multiple breakouts occurred in the same week, and at a time of extreme seasonal strength in coffee futures.

Those of you who have been with me for a couple months are already in this market with a profit and entered the week that coffee bottomed. For those who are not yet in the market let’s discuss how one can trade a breakout in prices with little risk and potentially high reward. The theory states that if prices break out from a range, then that force ought to continue until bear and bull are able to rebalance. If prices fall back into range, then the signal failed, and you don’t want to be in the market. This is a great trading strategy for those who want to ride a market for an extended period of time and need a relatively safe entry.

Just as you can place a stop loss order in the market to protect yourself from malignant market swings, so too you can place a stop order for purchases or short sales that ‘stop’ you into the market, rather than out of it. An order like this allows the market to tell you where it’s going, rather than trying to predict it yourself. The odd thing about this is you’ll usually trade contrary to conventional trading wisdom. Rather than buy low and sell high, you’ll buy high and sell higher. Rather than buy at the bottom of the range and sell at the top, you’ll place a ‘buy stop’ order just above the trading range, and if prices break out, then you’ll be stopped into a long position.

This is a hard concept for some to grasp at first because most will think, ‘well, if I’m getting stopped in at the top of the range, why don’t I buy before it breaks out and I’ll make a greater profit’. But those who trade know quite well that it doesn’t work this way. If the break out doesn’t occur, you’ll be long the market when it reverses on you. There is no guarantee of a breakout. If the breakout occurs however, you want to be in the show. So allow the market to tell you what it’s doing, rather than anticipating its direction.

This strategy relatively safe is because you have a clear line of value that has been long standing as resistance. Once that line is broken it usually becomes support, and provides a solid floor under the market. If prices that fall back into the previous trading range then the market has shown you it isn’t going where you need it to, and you ought not be in it. So as soon as you are stopped into the market, you can place a stop loss just under the support line, which is market by the previous highs in the price range. Sometimes you can enter a trade with only a few hundred dollars at risk that can result in a sustained bull run that rewards you with monster profits.

The Hound of the Baskervilles and the Signal of Failed Signals
Sherlock Homes was called to a country estate to investigate a murder. The family dog was present at the time of the murder, and for some odd reason no one heard it barking. Homes surmised that the lack of a reliable and regular response from a watchdog, that of barking if threatened, is in itself an important indication of the murderer’s identity. This implied that the dog knew the murderer and the lack of a signal became the signal.

A. Elder in ‘Trading for a Living’ discusses the importance of a failed signal from a reliable indicator. He suggests that if a signal is proved false through subsequent market action, then it indicates strong underlying fundamental forces at work that should not be challenged. For those who have the courage, Elder suggests reversing your position and holding on (don’t forget your stop losses) and riding this move for what’s it got, as it may result in a sharp and powerful move.

Playing this theory back in October would have saved a great number of people a great deal of money. Virtually every market indicator began to fail when the markets went to shit. Those that had the clarity to realize something was amiss and reversed their positions made a killing. Coffee futures, like every other market also broke down as indicators across the board simply stopped working. I know because I didn’t not heed the hound’s warning, or lack of warning so to speak.

Well I’m listening now. After bullish divergence accurately predicted the market bottom on March 3 in coffee futures, prices quickly rebounded to the $1.20 level, where a bearish signal was given by the MACD histogram on April 13th. This signal proved false as prices have surpassed $1.20 on the recent rally. The MACD has been working for the last several months, along with several other indicators. Its failure on April 13th suggests stronger underlying fundamental forces at work that could, in my opinion, prove to be quite explosive and fuel a nice bull run into June before seasonal weakness sets in.

At this time of great seasonal strength in coffee futures we’re experiencing several interesting and powerful signals. We have breakouts occurring in our five month trading range. We have a breach of the long term bear trend line. And we have the hounds telling us something is amiss and that underlying fundamentals may finally be dominating the trade. Futures trading is an incredibly difficult sport, but when indicators line up with fundamentals line up with seasonal factors line up with a recovery in commodities prices as a whole, we may be entering a very opportune time to play. Coffee futures trading is about to get very interesting.

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.