COT Short Sale Setup Preceding Seasonally Weak Coffee Market

Includes: CAFE, JO
by: COT Signals


The coffee market has rallied more than 10% from its recent lows.

The rally has attracted substantial commercial selling.

Coffee is typically weak preceding December futures' deliveries.

The commercial coffee producers have taken the upper hand in the December coffee futures contract ahead of seasonal weakness through month's end.

The weekly Commitment of Traders disaggregated futures report divides the markets into three basic groups: small speculators, large speculators, and commercial traders. Our thesis is that the commercial traders, whose interest in the futures markets relates solely to their business plan, ultimately prove to be correct in forecasting profitable turning points in many markets because they have better information than we do. Therefore, when the commercial traders are selling coffee futures ahead of seasonal weakness, we take note.

The first chart displays the mechanics behind our nightly COT Signals worksheet. We identify the commercial traders' momentum. We wait for the large speculators to overextend their position against the commercial traders' momentum. Once the market reverses back in line with the commercial traders' directional indication, we enter the market. Finally, and always, we place a protective stop loss order at the recently created swing high or low. The true discretionary nature of this setup lies in the profit taking.

coffee futures chart with commitment of traders analysis and seasonality

This is the setup we look for in our nightly Discretionary COT Signals worksheet.

It's no coincidence that the commercial traders have turned to the sell side ahead of the projected seasonal weakness through month-end. As you'll see below, the seasonal component we provide separately is strong enough to stand on its own. Feel free to view the seasonal results for verification. Our seasonal research is nearly ready to produce a short signal in the coffee futures. The Commitment of Traders analysis provides a sensitive tool for scalping in and out of the more broadly defined seasonal weakness.

Let's see what we expect from the coffee market over the next couple of weeks.

seasonal coffee trading program performance

This is the out-of-sample performance for the seasonal coffee futures model we'll be running.

Our standard delivery format for the seasonal trading program includes out-of-sample charts and Monte Carlo results adjusted to current market prices. The out-of-sample equity curve for the model is plotted in white, while coffee futures prices are plotted in yellow.

This is the out of sample closed trade equity curve for the coffee futures seasonal model be employing.

This is the out-of-sample closed trade equity curve for the coffee futures seasonal model we are employing.

More important than the equity curve are the Monte Carlo results. One of the biggest problems with seasonal trading is having such a small sample size with which to work. Monte Carlo testing helps provide a better, big picture of returns than the small number of trades that populate a given model's history.

The results below tell us that the model's average gain for this period is 5.86% with a standard deviation of 3.04%. This means that we expect two-thirds of our trades to fall somewhere between 2.82% and 8.9%. These returns are based on trading one contract of coffee futures with a point value of $375 on a $100,000 account to make the math simple. This equals a decline in the value of coffee and a profit to us of somewhere between 7.5 and 23 points per contract. Meanwhile, we'll only be risking 2% from the entry price or about 2.25 points.

Monte Carlo returns for seasonal coffee strategy

Monte Carlo analysis can provide a better estimate of returns in models with small sample sizes.

When it comes down to it, successful trading requires three things. First, a strategy with a mathematically positive outcome; an edge. Second, the money management skills to not only implement the strategy but also maximize its effectiveness through proper trade sizing. Finally, the biggest variable is number three; execution. We must stick to the strategy as closely as possible to generate similar performance.

Disclosure: I am/we are short DECEMBER COFFEE FUTURES.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.