Since surpassing the +$15k (premium cocoa) level last fall, we have been of the opinion that the cocoa/sugar spread will ultimately roll over and return to the ‘even money’ level. This is because the last few decades of price history implies that this spread is historically ‘expensive’ whenever it reaches +$10k or higher. And on those infrequent occasions when it has made it to the +$15k mark higher (this has only happened six times in the last forty years) it eventually reversed and dropped all the way back below the ‘even money’ mark.
The blog initiated a hypothetical short position in the May cocoa/sugar spread at the equivalent of +$12,098 (this was initially a March spread and then rolled to the May contracts yesterday) on October 3rd. The recent price action has provided another potential short sale setup. Therefore, a trader could use it to add to the current short position.
On November 14th the May cocoa/sugar spread touched a four-month low of +$9,763.60 (premium cocoa). It rallied from there and made a Fibonacci .618 retracement of the decline from the September multi-year top. The spread then rolled over and nearly returned to the November low when it closed +$9,848.40 on January 26th. It has since rallied to roughly $300 away from the January bounce high.
The similar November and January lows create a double bottom support level for the May cocoa/sugar spread. A potential trade off this pattern would be to go short on a break below the double bottom and risk above the bounce high (the highest high between these two lows). Currently, the risk on a trade with these parameters would be somewhere around $3k to $3,500. It’s hard to be exact, though, because you don’t know how far beyond the highs and lows the close will be to trigger the entry and exit signal.
With a minimum objective of ‘even money’ and a ‘guesstimate’ risk of a little more than $3k, the approximate reward-to-risk ratio on such a trade would be somewhere around 3:1. Given the fact that the initial short position would show a decent open profit by the time this second trade would get elected, it seems that this would be an acceptable ‘add-on’ trade for the May cocoa/sugar spread. Therefore, aggressive spread traders could use this to take advantage of the bearish trend that is unfolding.
For tracking purposes, the blog will make a hypothetical ‘add-on’ trade by selling one 10-ton May cocoa contract and simultaneously buying one 112,000 lb. May sugar #11 contract if the spread closes below +$9,700. If filled, risk a two-day close above +$13k. The exit level is above the January 12th high of +$12,885.20, which is the highest closing price between the November and January lows.