It’s been too long now since I’ve posted on coffee futures. Coffee news is exceedingly bullish, but this is quite typical for this time of year. That said, there may very well be something different this time around. We’re going into next season with the lowest stocks to usage ration on record, and all major producers are reporting smaller 2010 harvests.

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.

Well, your perennial coffee futures bull is a tad lost for direction. It’s been a while since the last post, and for good reason. I haven’t seen anything worth commenting on. Coffee futures seem to have put in a solid bottom, and are looking now for confirmation. But the fundamental picture is not what it was a couple months ago.

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.

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.