Is The Bull Market In Cocoa Starting To Melt In Traders Hands?

Fundamentals

Cocoa futures have been in a bull market for most of 2009, as solid demand — especially in Europe — and another disappointing Cocoa harvest in the Ivory Coast have had traders in a bullish mood. However, volatility has increased the past several sessions, which may force weak longs out of the market. On Friday, a report from the European Cocoa Association (ECA) showing European Cocoa grind was up over 16% in the third quarter sent Cocoa prices sharply higher. However, the ECA later retracted the report, saying a statistical error may have skewed the data and that the organization would be issuing a revised report on October 13th. This news sent prices plummeting off the highs, triggering sell stops along the way. Overshadowed by the erroneous data in the ECA report was the increase in U.S. Cocoa bean exports which were up 55% from year ago levels. News continues to circulate from the Ivory Coast, the world’s largest Cocoa producer, that this year’s production will continue to lag earlier expectations, despite relatively good weather conditions. Bean quality has also been a disappointment this season, with buyers blaming high prices for fertilizers for forcing many producers to forgo its usage, which has affected both crop size and quality. There is better news out of Nigeria, where traders are looking at a sizable harvest from the 2009-10 main crop, which is expected to start in earnest in November.

Both large and small speculators are holding net-long positions in Cocoa futures, according to the most recent Commitment of Traders report. As of October 6th, non-commercial traders where holding a combined net-long position of 30,320 contracts, up 1,238 for the week. Though not a record long position, Friday’s reversal on the daily charts may trigger some long liquidation, as sell stops are high below recent support points. Though the fundamentals appear to continue to favor the bulls, traders should prepare for increased volatility in the Cocoa market near these lofty price levels.

Trading Ideas

More conservative traders who wish to hold a bullish position in Cocoa but hope to withstand the increased volatility seen the last several sessions may possibly want to investigate option strategies in Cocoa. One such strategy would be buying bull call spreads in Cocoa options at least 3 months out. An example would be buying the March Cocoa 3200 calls and selling the March Cocoa 3600 calls. With March Cocoa trading at 3102 as of this writing, the spread could be bought for 150 points, or $1,500 per spread, not including commissions. The premium paid would be the maximum risk on the trade, with a potential profit of $4,000 minus the premium paid, should March Cocoa be trading above 3600 at option expiration in February.

Technicals

Looking at the daily chart for December Cocoa, we notice that Friday’s price reversal after making 15-month highs sparked some serious long liquidation on Monday. Prices fell below the 20-day moving average, which is viewed as a “sell” signal by many short-term momentum trading systems. However, last week’s lows of 2967 have not been taken out and may act as a short-term support point should the sell-off continue. Longer-term support is seen at the 100-day moving average, currently near the 2840 area. Friday’s highs at 3329 should act as near-term resistance in the December contract, with longer term resistance found at 3400.

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