Arabica Coffee/Robusta Coffee Spread
The Arabica coffee contract and the Robusta coffee contract are highly correlated. Even though the Arabica beans and the Robusta beans are grown in different places and are different grades of coffee (the Arabica is the ‘good’ stuff that you drink at Starbucks and what-not while the Robusta is the ‘cheap’ stuff used to make instant coffee), the price of one market is closely tied to the other.
Over the last couple of decades the peaks and troughs in the Arabica and Robusta coffee markets occurred around the same time. The explosive bull market rallies and devastating bear market declines in one market was accompanied by a similar move in the other market. Choppy multi-month trading ranges in Arabica or Robusta kept the other market held hostage in a trading range as well. These two markets are joined at the hip as the correlation is undeniable.
The ratio between the value of one 37,500 lb. Arabica coffee contract and one 10-tonne Robusta coffee contract reached nearly 3.9:1 when the recent spread contract high was posted on October 14th. This level is getting up there. A ratio of 4:1 or higher has only been achieved four times in the last few decades. However, the last four times it reached 4:1 the ratio hit a blow-off phase and surge further before the final top was made.
After breaching 4:1 in late 1996 the ratio rocketed to 5.8:1 before rolling over and crashing. When 4:1 was exceeded in 2000 the ratio made it to nearly 4.8:1 by late 2001 and then reversed sharply. The ratio hit 4:1 again in 2004 and was catapulted to nearly 5.5:1 before it went into a nearly three-year bear market. The last time the ratio hit 4:1 was in 2009. It proceeded to climb for another two years and finally peaked at approximately 4.8:1 in 2011. It plummeted to a multi-year low from there.
Where Has This Coffee Spread ‘Bean’
Since the ratio between one 37,500 lb. Arabica coffee contract and one 10-tonne Robusta coffee contract closed at 3.76:1 on Friday lets round it up to 4:1 and create a spread between one Arabica coffee contract and four Robusta coffee contracts. This will help normalize the position to make it something that’s tradable.
The value of one Arabica coffee contract is approximately -$5k less than the value of the sum four Robusta coffee contracts. The spread between the March Arabica and Robusta (x4) contracts posted a contract high of -$2,703.75 on October 14th. This is pretty close to the ‘even money’ mark.
In the last quarter of a century, there have only been four occasions where the Arabica/Robusta (x4) coffee spread has reached ‘even money’ or higher. Each incident lasted a few months and three of those times it went to +$10k (premium Arabica) or higher. Ultimately, however, the spread reversed and dropped back down to -$30k or lower.
Based on this history, it seems doable that the spread could still run up several thousand dollars more from here. However, history also indicates that this will not last. A major decline should eventually take place. As a spread trader, one could have the best of both worlds by riding the blow-off phase of the coffee spread to higher ‘grounds’ and then flipping over to play the reversal.
Current Market Situation
Arabica coffee more than doubled in price this year as crops suffered when Brazil (the world’s largest Arabica coffee producer and exporter) experienced the worst drought in decades. The market dipped into July, but recovered to a new multi-year high this month on ideas that the supply is still tight.
In the meantime, Robusta coffee is lagging behind as Vietnam (the world’s largest Robusta coffee grower) is expected to reap a near-record harvest.
This divergence in the state of the two crops has caused the price disparity. This will be rectified at some point. History shows that a ratio of 4:1 or higher is ultimately unsustainable. Something has to give. The Arabica coffee will spill, Robusta coffee has to perk up, or there will be some combination of the two. A spread trading opportunity in the coffee market is brewing!
Trend Change Signals
There a couple of possible setups that could signal a bearish trend change for the Arabica/Robusta coffee (x4) spread:
First, a close below the rising weekly 30-bar Moving Average, basis the nearest-futures (somewhere around -$11,490 on Monday) for the first time in one-quarter of a year could signal a bearish trend change. The three-week break in late June/early July is the only time in 2014 that the Arabica/Robusta coffee (x4) spread has been below the rising weekly 30-bar MA.
Second, a break of the early September intermediate correction low of -$11,631.25 would alter the weekly price structure of higher highs and (mostly) higher lows. A break of the early July major correction low of -$20,393.75 would confirm it.
Daily Chart: The Day of Reckoning Is Here
On the daily timeframe, the March Arabica coffee/Robusta coffee (x4) spread has reached a do-or-die level. The spread posted a contract high of -$2,835 (premium the sum of four Robusta contracts) on March 5th, it plunged to approximately -$17k by July, and then rallied for the last three months to marginally post a new contract high of -$2,703.75 on October 14th. The early March and mid-October highs are less than $1,000 away from the Fibonacci .618 retracement of the entire 2011-2013 collapse.
Follow-through to the upside could send the spread soaring toward the 2011 bull market high of +$18,810 (premium Arabica). Conversely, a drop from here could establish a double top on the charts. Either way, the spread could be in for a move of $15k or more from current levels.
At current levels, one strategy that a trader could use is a reversal system where a position is always in the market, long or short. The trick, of course, is to determine the price levels that will trigger buy signals and sell signals.
On the upside, a buy signal could be set at -$2k. This price is several hundred dollars above the potential double top between the early March and mid-October highs. On the downside, a sell signal could be set at -$6k. This price is below the 20-day Moving Average and at a level that the spread has not seen in three weeks.
For tracking purposes, the blog will hypothetically implement a reversal system for the March Arabica/Robusta coffee (x4) spread with a position consisting of one 37,500 lb. March Arabica coffee contract and four of the 10-tonne March Robusta coffee contracts. A long spread position (long Arabica and short Robusta) will be initiated on a close above -$2k and a short spread position (short Arabica and long Robusta) will be initiated on a close below -$6k. Each price level will act as a stop and reverse point. For example, if a long position is entered on a close above -$2k then a close below -$6k will trigger a signal to liquidate the long position and initiate a short position. If a short position is entered on a close below -$6k then a close above -$2k will trigger a signal to liquidate the short position and initiate a long position.