The coffee market is what you’d call a professional traders market. It is a large and volatile contract, which leads to equity swings that are too large, even with a single contract for small traders to withstand. Furthermore, commercial traders dominate the market through their access to global information and deep pockets. The coffee futures market has been in decline since May of last year, losing half its value from the $3.08 per pound high. Even with the decline in volatility as the market has collapsed the average daily range over the last month is still nearly $.04 per pound which equals an average cash account fluctuation of $1,500 per day, per contract. Those wishing to participate in the coffee market without the use of leverage may want to look at the coffee Exchange Traded Fund – JO.
The May highs are a good place to start looking at the commercial traders’ forecasting ability in this market. The International Commodity Exchange in New York, formerly the New York Board of Trade held 1.6 million bags of coffee in their warehouses when the market made its high last year. Commercial traders sold into this rally and accumulated a net short position of more than 38,000 contracts. As you might expect, this left small and large speculators with their largest position of the rally, right at the top.
The next piece to look at is the Commitment of Traders Index. This is the most common tool used to measure the participation of the primary market participants; commercial traders, large speculators and small speculators. The index normalizes the total position to a 0-100 scale. Zero is the most bearish and 100 is the most bullish while crosses above 70 and below 30 indicate overbought and oversold levels and sets traders up with a trigger mechanism. This tool would have been of little use as the market declined since the index has been stuck above 70 for commercial traders since late September of last year as the commercial traders began buying to cover their short positions initiated last May.
This is why we analyze the raw data and scale it down to daily levels with appropriate stop loss placements. As a trader myself, I have to look for opportunities to maximize my time in the market and the less time I spend in the market, the less overnight or, news event risk I have to take on. We’ve picked up eight trades since last September using the daily method we publish with 6 of them being winners, including buying the June lows and selling the July highs.
Coffee hasn’t been this cheap since June of 2010. Coffee warehouse stocks at this time were 2.2 million bags and the commercial trader position was net long 26,000 contracts. Currently, warehouse stocks are 2.5 million bags but, more importantly, the commercial long position is now more than 56,000 contracts. This also sets a record in managed money short positions. Referring back to the 2010 lows, we saw the same situation without quite the levels of determination by the market’s participants and that imbalance led to a 13% rally in eight trading sessions and was worth $8,250 per contract.
I’m not suggesting that the market is immediately set to turn around and put $8,000 in anyone’s pocket by Christmas. I am suggesting that the coffee market is extremely oversold. The typical resolution to this market’s imbalances lies in favor of the commercial traders. Furthermore, any managed money in the futures market that has called for redemptions due to the pending tax changes will see their profitable positions offset. This could fuel some buying and get the ball rolling.
Finally, it’s important to track the markets’ players and keep track of the winners and losers. This requires a greater attention to detail than just a quick glance at a normalized index. Tracking the raw data for each trader category allows us to compare historical levels of trader involvement as well as tracking their movement relative to warehouse stocks to ascertain the degree of scarcity in a market.
We will be actively looking for opportunities to buy the coffee market and fully expect at least a tradable bottom being formed somewhere in the $1.40 – $1.50 range.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.