Last week coffee futures provided us a great opportunity to test a couple different futures trading strategies. Coffee confirmed a failed signal from the MACD Histogram while simultaneously breaching the long term downward trend line and threatening to breach the long term resistance line around $1.26. In this post we’ll look at trading breakouts and the importance of failed signals with our beloved coffee futures as exemplar.

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.

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.

Futures Trading is as complicated as it sounds, and as risky as people make it out to be. But once a basic understanding of the way the futures markets work, and a working knowledge of one or two commodities or stock index futures is had, futures trading can be a risk well worth taking.

Futures, as the name implies, are contracts on an asset to be delivered at some future date. To make these examples simpler to understand, I’ll use our beloved coffee futures as an example. Coffee futures are traded for five months throughout the year. Which means that if I purchase one May futures contract, and I don’t liquidate (or sell) that contract before it expires, then some time in early may 37,500 lbs of coffee will show up in a warehouse with my name on it and a rather large bill. If I sell this contract prior to expiration however, I only need to worry about profit and loss as related to the paper contract itself, the price of which is determined through free trade on the ICE exchange.

For any commodity, there are a few factors we need to understand before entering a position:
1. What is the size of the contract per commodity?
2. What is the margin requirement and maintenance margin requirement?
3. On a relative basis, how volatile is my chosen market?

(Notice here I am not discussing fundamental factors. While these do influence futures in the long run, they are a futures trader’s worst enemy in the short term. Investing and trading, while in principle are virtually the same, they differ in duration, and this makes them nearly diametrically different in practice.)

The size of the contract is important because it tells me the significance of price movements as it relates to my own profit or loss in that market. For example, a coffee futures contract, as we said, is 37,500 lbs. This means that for every penny that the price raises, I make $375. Likewise, for every penny that coffee futures fall, I lose $375. Depending on my risk tolerance or whether I am trading for short term or long term gains, this knowledge allows me to create a risk-reward money management system for this commodity.

In case you haven’t noticed, one coffee contract is worth a great deal of coffee and cash. And the price of a full contract is too rich for the blood of most speculators. Futures trading allows speculators to own enormous quantities of a commodity for a small sum of money, called margin. At present, the initial margin requirement on a coffee futures contract is in the neighborhood of $3,000. So for that small sum I can control a contract that at current prices represents approximately $45,000. That my friends is the definition of leverage, and there is no investment category out there with more leverage than futures trading. (Possible exception being real estate)

If the price rises a mere 10 cents, then I more than double my initial margin. If coffee futures fall a mere 10 cents, then I lose more than 100 percent of my risk capital. This is where the game shakes out those with a weak stomach. Because of the immense leverage, it is essential to trade according to a reliable system that incorporates both reliable technical indicators and sound money management practices. These are large topics themselves beyond the scope of this post. Nevertheless, they should be structured carefully around our third factor, volatility of our chosen market.

Futures trading is not only notoriously difficult to make money in, futures markets are also notoriously erratic and unpredictable, at least in the short term. Volatility is an inherent characteristic of free trade. The markets are in a constant state of flux, never remaining at one price for longer than a few seconds. So as we select a market, volatility should be a determining factor. Let’s say I have a $20,000 trading account (too small for a beginner), and I want to trade a market like coffee.

At present coffee futures are not terribly volatile (compared to its historic levels). Prices will fluctuate 1 to 8 cents a day. This means that if I want to give this market enough time to make me some money, I probably need to risk 10 cents so I don’t get stopped out on a simple price drop, in addition to buying strategically. This would require me to risk about 20 % of my account equity on a single trade, far too much to risk on a single trade.

Most money management systems consider risking anything more than 5% on a single trade careless, and most professionals don’t risk more than 2 %. This requires either a large trading account, or limiting your trading to markets that are less volatile or require less risk capital. Sugar or cotton futures may be an alternative. Something all those out there should keep in mind is that you are going to lose money in this game in the beginning. And the smarter you think you are, the more you stand to lose.

Futures trading requires you to think in terms of probabilities, and most people of average to high intelligence think in terms of absolutes. And because intelligent people are confident, they don’t take prudent precautions from unforeseen potentialities and their own ignorance. Doctors and lawyers throw a great deal of money into the futures markets and they are notoriously bad traders.

If you are right 60% of the time in futures trading and you apply a sound money management system, that is enough for you to make a great deal of money in the long run. If you’re right 60% of the time as a doctor or lawyer you kill clients and get canned. Futures trading requires you to think in terms of minimizing risk, an exceedingly difficult concept to apply when you believe you’re right about a trade (I speak from personal experience here). It is those who are convinced their view is right who lose the most money. It is the experienced speculator who lets the market tell him he’s right, rather than assuming the market will eventually capitulate to his convictions.

Trading this way requires you to find a system that defines your risk per trade based on the size of your account equity. This system needs to assume that you are going to be wrong 40 or 50 % of the time, and still needs to show you a healthy return on investment. Sound strange? I thought so too at first. Read a book or two on betting strategy in gambling, it will give you a sobering look at a long term risk-reward strategy based on probabilities. This system should contain indicators that define and identify trends, ranges, and reversals. These are indicators which in essence show us market sentiment.

In every price move there is a story of two forces colliding, a battle on the day, week, or month. Indicators should do more than interpret the past price movements, they should read the complex psychological factors influencing the current price. They should tell us when bulls are gaining strength, and when bears are getting tired. They should tell us when all the buying has been done on a long term historical basis, and if these forces are growing in strength or weakening. The best resource I have for all this is A. Elder’s “Trading for a Living”. This book contains 80 % of all the futures trading info you will ever need to learn. The other 20 % will come from studying the markets and getting burned a few times.

Regardless of the pain and suffering futures trading has put me through at times, it has enriched my life all the more. I can’t imagine my life without it.

Well, for those of you who read the last coffee futures post and took action, you’re sitting on 100% profit already after having risked less than 25% of your initial margin to enter the trade.  Not too shabby.  Your average trader would take profits here, but I am not looking for small gains.  We want to ride this market for all its got, and that’s where things get tricky.

The technical picture here is textbook bullish.  Coffee rebounded off the lows after retesting the long term bottom, and it did so with bullish divergence from the MACD and RSI, as we discussed last time.  This time I’d like to point out another promising development, which is the crossing of all three moving averages. 

I typically observe the 20 day moving average more so than the others, but I don’t mind it at all when prices confirm a clear change of short term trend by blowing past all three.  As you can see, the red and green lines were quickly left behind, representing the 8 and 18 day moving average.  For trend followers, which includes most of the ‘big money’, this week’s action is decidedly bullish and a good opportunity to enter the trade. 

This strong technical setup in conjunction with the news I offered last time about the rising Columbian differentials could be the complete bull case.  We should see a little more action from here on out, so hold on tight.  We are now finding that rare occassion when fundamentals and technicals are decidedly aligned for coffee futures.  We are long from $1.05.