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GAPS


July Cocoa's Island Gap: Prelude To A Break

04/12/05 10:27:47 AM
by David Penn

A deep moving average convergence/divergence histogram trough suggests lower prices ahead for July cocoa.

Security:   CCN5
Position:   N/A

The last time I wrote about cocoa futures it was in anticipation of a swing trading opportunity to the upside ("Cocoa Pops," Traders.com Advantage, December 7, 2004) based on signals provided by the moving average convergence/divergence histogram (MACDH). For better or worse, the present analysis of cocoa futures has no such directional certainty.

What are the dominant technical features of July cocoa (CCN5)? A year-to-date chart of cocoa futures (Figure 1) shows a strong rally from the lows in mid-January, a rally that sees futures gain about 400 points in a little over two months. A negative stochastic divergence, however, anticipated a correction of some sort later in April (note that an earlier negative stochastic divergence in early March--March 8, to be specific--provided a signal but no entry).

Figure 1: Cocoa. The MACDH trough extreme in late March suggests lower prices ahead--even if July cocoa manages to drift higher from its oversold condition.
Graphic provided by: Prophet Financial, Inc.
 
Some negative stochastic divergences lead to sideways action rather than an easily tradable move to the downside. I have been reminding those intrigued by using such divergences to play tops and bottoms, pullbacks and bounces, in markets. However, the divergence in cocoa in late March was clearly one of the "collapse" varieties, as prices plunged from the 1850 area down to 1600 in about three days. That collapse, which began with a massive gap down, has July cocoa trading in a misshapen diamond pattern below both its 50- and 10-day exponential moving averages (EMAs).

Generally speaking, consolidations that occur in aggressive trends (and the collapse in mid-March, on increasing volume, no less, was certainly "aggressive") tend to be continuations rather than reversal patterns. While it is too early to tell whether that will be the case with July cocoa, there are a few things worth keeping in mind as the path of least resistance is eventually revealed.


First, with July cocoa trading under its 50- and 10-day EMAs, the only thing that would be bullish about the current technical environment would be a positive stochastic divergence. July cocoa has come close to creating one in early April, but there remains to be established a clear higher low in the stochastic to match the lower low in cocoa futures. Given that cocoa has made a lower low in April vis-a-vis March, a higher low in the stochastic in April would provide a buy-side entry target price (with the lows of the pattern being the "tap-out" level).

But that higher low has yet to occur. And until it does, buying cocoa futures at these levels is probably more a show of faith than a technically sound trading decision. A significantly enough negative day in the near term, for example, could create a reversal in the MACDH back to the downside. Insofar as July cocoa's MACDH has been rising ever since making a trough low on March 29, a downside reversal would create a sell-side entry target price below the current consolidation, which, if hit, would suggest a test of the January lows near 1475.


One last item worth bringing up also regards the MACDH. The MACDH trough from mid-March to mid-April reached lows not seen in this commodity in at least a year. Extreme MACDH troughs tend to suggest that lower prices are ahead--albeit occasionally after a bounce of some sort. So even if July cocoa were to provide the sort of positive stochastic divergence that would create a buy-side entry point, traders taking advantage of such an opportunity on the long side may want to be cautious of a reversion back to the downtrend begun in mid-March--particularly as the March gap down level between 1675 and 1750 nears.



David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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