Time to Roll and Time to Add
It’s almost Valentine’s Day. Time for love…and chocolate candy! Which reminds me: the First Notice Day for March cocoa is on Tuesday. So, outstanding long positions will have to be rolled before the long weekend. (The US markets are closed on Monday for President’s Day). Although we’re short the March cocoa and don’t necessarily have to roll yet, it may not be a bad idea to go ahead and do so. This keeps us in the contracts with the most liquidity.
The blog entered a hypothetical short position in the March cocoa/sugar (x2) spread at +$2,318.80 (premium cocoa) back on September 30th when the spread made a two-day close below the rising 50-day Moving Average for the first time in several months. We are simply going to scoot over to the May contracts.
The bearish trend change was triggered just a couple of weeks after the cocoa/sugar (x2) spread had reached a twenty-nine year high of +$8,559.60 (premium cocoa) on the weekly nearest-futures chart.
Even more interesting is the fact that the peak took the spread just past the double top at the 2002 and 2008 highs. This triggered a Wash & Rinse sell signal when the attempted breakout failed.
History Favors More Downside
In the past, rallies to +$4,500 (premium cocoa) or higher on the nearest-futures monthly chart lay the foundation for short sale opportunities in the cocoa/sugar (x2) spread. The trick, of course, is to identify the trend change and get in. After a couple of false starts, it appears that we were finally able to accomplish this.
Previous peaks at +$4,500 (premium cocoa) or higher were followed by bear market declines that took the spread back under -$20,000 (premium sugar). This level is our minimum downside target, so it still has quite a ways to go. Therefore, it makes sense to look for setups to add to the position and try to maximize the profits.
Current Price Pattern
Since October, the spread has closed below the weekly 50-bar Moving Average every single week. Prior to that, the weekly 50-bar MA had been acting as support on every pullback since April of ’09. Now that it has been broken, the weekly 50-bar MA has become technical resistance.
On the daily timeframe, the May cocoa/sugar (x2) spread spent most of October and November in a choppy trading range. After popping up nearly $3,000 from the October correction low and tagging the declining 75-day Moving Average in mid-December the spread rolled over and sank to new multi-month lows in the weeks that followed. This indicated that the 75-day MA is a resistance level to be monitored.
Therefore, is it any surprise that the recent bounce was stopped again by the 75-day MA on February 1st? And if that’s not enough, the rally also put it just $40 away from the Fibonacci .618 retracement of the decline from the mid-December peak.
In addition, the spread rallied about $3,600 off the January correction low. This was just a little bit bigger than the prior rally off the October correction low. Seems like it might be a good location to add to short positions.
The weekly 50-bar MA currently provides resistance at +$1,830 (premium cocoa) and the mid-December rally high is just a bit higher at +$2,006.40 (premium cocoa). This resistance area should be another fortress to stop the bulls if the spread does not roll over right around here. Therefore, placing protective buy stops above this area seems like a good strategy.
If a trader could sell the rally and risk just above the mid-December rally high, the risk would be somewhere between $2,000 and $2,500. With a minimum downside target of -$20,000 (premium sugar) the reward-to-risk on the trade is somewhere between 8-to-1 and 10-to-1. That’s a good profile.
On the hypothetical short March cocoa/sugar (x2) spread entered at +$2,318.80 (premium cocoa) on September 30th, roll to the May contracts at the market-on-close on Friday, February 12th. Risk to a two-consecutive day close above +$7,500 (premium cocoa).
Trade Strategy for ‘Add-On’ Position:
Work a hypothetical contingency order to sell one 10-ton May cocoa contract and simultaneously buy two 112,000 lb. May sugar contracts on a rally to -$500 (premium sugar). Initially, the ‘add-on’ spread will be liquidated on a two-consecutive day close above +$2,000 (premium cocoa).