Cocoa/Sugar Spread: Another Short Sale Setup

Riding the Bear

The IMC blog is holding a hypothetical short position in the May cocoa/sugar (x2) spread that was entered on September 30th from the equivalent of +$2,856 (premium cocoa).  A second ‘add-on’ position was then entered at -$500 (premium sugar) on February 18th.

The recent price action has provided a setup to sell another cocoa/sugar (x2) spread.  This time, we are going to focus on the July spread since the May spreads will be rolled over in the next week or so.

Last September the cocoa/sugar (x2) spread was trading at a multi-year high.  It then gave up the ghost and triggered a short sale signal.  By all appearances, this was the start of a bear market.

July Cocoa Sugar (x2) spread daily

July Cocoa Sugar (x2) spread daily

The fourth quarter started with a break below the rising 100-day Moving Average for the first time in several months.  Once this technical support level was breached, it turned into a resistance level.

The 100-day MA has proven its worth so far.  After bottoming in early October, the July cocoa/sugar (x2) spread rallied for over two months.  It peaked after tagging the 100-day MA.

The spread once again posted a short-term bottom in mid-January.  A one-month rally followed and the spread once again crested after tagging the 100-day MA and backing down.

Another Short Sale Opportunity

The July cocoa/sugar (x2) spread reached a sixteen-month low in late March.  It then snapped back into mid-April.  At last week’s high, the spread was just $650 away from the 100-day MA.  Boy, this could have been a perfect setup: Get a test of the 100-day MA and then sell another spread if it backs off within a day or two.

Alas, Willy Wonka did not grant our wish!  The July cocoa/sugar (x2) spread fell nearly $1,900 on Friday as the sugar market exploded higher.

Be that as it may, this may still be a good time to sell short.  The recent break off the mid-April high does have some similarities to the nearly $2,400 four-day drop that occurred right after the mid-December high and the $2,100 one-day drop that occurred right after the mid-February high.  Therefore, the blog is willing to increase the short position right here and risk above last week’s high.  In just a couple of weeks, the 100-day MA should be near or even below the April 14th high.  This will serve as a technical reinforcement level.

Cocoa Sugar (x2) spread (nearest-futures) weekly

Cocoa Sugar (x2) spread (nearest-futures) weekly

From a reward-to-risk perspective, a short sale right here looks pretty lucrative as well.  If we short it at -$4k and risk to -$2k, the risk would be approximately $2,000.  Keep in mind that our minimum downside target for the cocoa/sugar (x2) spread is -$20,000 (premium sugar).  Therefore, we’d stand to make $16,000 on a short sale from here if the minimum target is reached.  Risking $2k to make $16k is a reward-to-risk ratio of 8:1.  Can’t beat that with a stick…or a chocolate bar.

Trade Strategy for ‘Add-On’ Position:

Work a hypothetical contingency order to sell one 10-ton July cocoa contract and simultaneously buy two 112,000 lb. July sugar contracts on a rally to -$4,000 (premium sugar).  Initially, this ‘add-on’ spread will be liquidated on a two-consecutive day close above -$2,000 (premium sugar).   

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