​Using Divergence to Trade Cocoa

Andy Waldock  |

The group of markets known as the, "softs" or, "exotics" include markets like coffee, sugar, orange juice and cocoa. These are all traded on the Intercontinental Exchange and each market marches to its own beat. These markets are known for their volatile moves but rarely get the trading attention they deserve. For some, like orange juice, it's due to low trading volumes that make it tough to execute any more than a couple of contracts. However, others like coffee, sugar and cocoa have more than enough volume to handle 10 contracts or more in a single execution. Finally, because these markets have little correlation to the majors, their analysis is frequently overlooked. Today, I'll review one of my favorite trading techniques in these markets and detail the current situation setting up in the cocoa futures market.

First, some background. The cocoa market is undergoing a dramatic transformation as modern farming practices and a more transparent investment structure begins to take shape in the democratizing Ivory Coast under the stewardship of the Western educated and former International Monetary Fund deputy head, Alassane Outtara who was just elected to a second Presidency term in October. This comes after decades of oppressive dictatorial regimes. The practices currently taking shape will dramatically increase the productiveness of Ivory Coast cocoa farmers and structurally impact the quality and availability of cocoa on the open market. Meanwhile, much of the recent rally has been based on the perceived threats of the record setting El Nino weather patterns currently in effect. We've written extensively on the El Nino impact, including its effect on the cocoa market. You can read more in, "El Nino and the Global Grain Markets," but to summarize, it's typically a case of, "buy the rumor, sell the fact."

This brings us to the current situation and trading opportunity. In a market with few correlations and a relatively limited geographical production base, analysis can be tricky. News may or, may not be reliable and boots on the ground reports are nearly impossible to come by. This makes the Commitment of Traders report an invaluable tool. The commercial trader section of this weekly report shows the actions of the commercial traders within this marketplace. Actions speak louder than words and commercial traders are now net short more than 75,000 contracts as the market threatens its all-time high at $3,775 per metric ton. There are only three periods in more than 30 years worth of cocoa's history where the commercial traders have been this heavily short and all three of them have come during Outtara's Presidency. Cocoa growers clearly feel that they'll not be able to sell at these prices by the time harvest comes and are therefore, selling all the forward production they can while prices are high.

That covers the fundamental angle. Now, we'll finish with a technical trading lesson. Looking at the chart below let's make some key points. First of all, we've only labeled the bearish divergences. Astute traders will note at least two successful bullish divergence patterns as well. This strategy works on both the long and short side of the market. We've only covered one side in the interest of simplicity. Each bearish divergence shows the following two characteristics. First, a second new high for the move must be made on a lower or, equal short-term market momentum reading. Secondly, commercial momentum must be negative upon the second, new high. This combination creates a setup for momentum failure and shows that the market is not supporting the new high. We sold March cocoa futures into its recent high. Based on today's action, we'll place a protective buy stop above the recent high at $3,415. Meanwhile, we'll let the commercial traders tell us if El Nino fears are warranted or if this becomes a case of much ado about nothing. Finally, this type of low risk, high reward setup is the foundation for our trading at CotSignals.com. Stack the odds on our side, take action, place our protective stops and let the market, via the collective wisdom of the commercial traders tell us when to exit.

Trading divergences using the commercial traders' actions from the Commitment of Traders reports is a proven method for taking advantage of the small uncorrelated markets traded at the Intercontinental Exchange.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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