Coffee's Bear Flag

04/12/05 10:29:05 AM

by David Penn

Negative stochastic divergences and a bearish flag hint at lower prices for coffee in the near term.

Security: KCK5
Position: N/A

It's been many, many moons since I last wrote about coffee futures. Back then, in June 2004, I was looking at a commodity that seemed poised to rally and rally big ("Coffee's Summer Rally," Traders.com Advantage, June 11, 2004).

While the advance in coffee since the late spring 2004 lows has been an extended and (at times) maddening affair for many (paging August 2004 ... white courtesy telephone for the August 2004 lows ...), those who adopted a bullish attitude toward coffee futures in mid-2004 have been well rewarded in the months since. Breaking out above the mid-summer 2004 highs near 87 cents in November, coffee (basis continuous futures here) rallied to a high of $1.37 by mid-March 2005. See Figure 1.

Figure 1: Coffee. Note how the lower boundary of the bear flag is virtually identical to the support provided by the 50-day EMA. Patterns and indicators rely on the same information (price and time), so it should not be surprising to find them reinforcing each other from time to time.

Graphic provided by: Prophet Financial, Inc.

That, as they say, was then. In the days and weeks since coffee tested the $1.40 level in mid-March 2005, everybody's favorite pick-me-up has started to correct its advance. This correction was anticipated by negative stochastic divergences not only in the daily chart of coffee futures but in the weekly charts as well. Whether this fact underscores the severity of the post-divergence breakdown or merely serves as a marker of the certainty is impossible to know. But those kinds of negative divergences are not worth fading, in my opinion.

The correction that has unfolded initially took coffee futures below their 10-day exponential moving average (EMA), and found support on the 50-day EMA. The 50-day EMA might be said to separate the "men from the boys," or more appropriately, the buyable dips from the destructive breakdowns. In other words, advancing markets that retreat to the 50-day EMA often find strength and support there. Those that don't find strength and support tend to find weakness and, often, sharp declines.

And a sharp decline is just what coffee futures are experiencing as the market moves toward mid-April. What is interesting is that this particular break was set up by a bearish flag pattern that saw coffee futures skate along support on a rising 50-day EMA before slipping and falling lower. The flag pattern simply refers to a short-term consolidation within a trend that is bound by a pair of parallel lines. It is important to note that this consolidation is brief; more than a few bars and flag patterns are more likely wedges or some other type of formation. Another important factor is that these consolidations tend to move counter to the prevailing trend. Thus, a bull flag in an uptrend would have prices moving sideways to lower, while a bear flag in a downtrend would have prices moving sideways to higher.

The latter appears to be in evidence here: a sideways to lower consolidation over about nine days shortly after a market rolled over and begin heading downward.

What does the bear flag suggest about near-term destinations for coffee prices? The measurement rule provided by Thomas Bulkowski in his book ENCYCLOPEDIA OF CHART PATTERNS calls for measuring the length of the move before the flag develops and (for a bear flag) subtracting that amount from the value at the breakout. In the case of May coffee, the distance from the mid-March top at 140 to the bottom of the formation at 120 is 20. That value subtracted from the top of the flag pattern (about 130) gives a minimum projected downside of 110.

Interestingly, the 110 level corresponds with the largely sidways trading in coffee futures during December 2004 and January 2005. It is hard to say whether coffee will find support at these levels. But as my old biochemistry teacher used to tell us at the end of just about every other lecture, "This seems like a good place as any to stop."

It's only a matter of time before traders learn whether May coffee agrees.

David Penn

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

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