Cocoa Comes Crashing Down

08/18/05 08:07:19 AM

by David Penn

No signal? Try switching time frames. Trading opportunities may be larger than they appear.

Security: CCU5
Position: N/A

One of the most frustrating things about relying on a mechanical (or semimechanical) trading method is that there will be instances during which you are fairly positive that a given market move is likely, yet your method provides no trading signal. The classic example is the technicality: your system or method says X number of consecutive closes above a certain moving average means that you cannot take a short position--until the market moves below that moving average. Yet you are convinced that the market is vulnerable to a decline. What do you do?

This is precisely what confronted my analysis of September cocoa in early August (Figure 1). The bear market in cocoa had been clear and pronounced since March, with the commodity topped out and beginning its stark decline. As such, most traders likely were in a "sell the bounces" mode until the market was ready to prove them wrong with a significant rally with volume (a rally without volume, to borrow from an old school rap, is like corn flakes without the milk).

Figure 1: Five consecutive closes above the 50-day EMA told me to look elsewhere for a commodity to short. The absence of a negative stochastic divergence on the high in early August was also a strike against going short.

Graphic provided by: Prophet Financial, Inc.

One of the more interesting discussions I heard at the Chicago Trader's Expo in July was from Brandon Frederickson, trader, hedge fund manager, and contributor to the Market Vu radio program (http://www.themarketvushow.com). Frederickson's message was simple but effective: combining time frames is not only an excellent way to improve the risk/reward ratio of a given trade, but it is also a good way of finding opportunities in the shorter time frame that are unclear--or even apparently nonexistent--on the longer time frame.

Figure 2: While still trading above the 50-bar EMA, cocoa revealed on this hourly chart a negative stochastic divergence from late July to early August that helped anticipate the reversal back to the downside.

Graphic provided by: Prophet Financial, Inc.

Look at the chart of September cocoa in Figure 2. Here, the time frame is hourly instead of daily. On the one hand, as with the daily chart, we have a market trading above its 50-bar (50-hour, in this case) exponential moving average (EMA). This would generally rule out a short of cocoa on the hourly level as well. However, note the divergence between price and the stochastic that occurs between the morning of July 27 and the morning of August 2. While prices were making higher highs between July 27 and August 2, the stochastic was making lower highs.

This negative stochastic divergence in the hourly chart reveals underlying weakness in the advance to the August 2nd high that was not observable to the naked eye fixated on the daily chart. It was this sort of time frame analysis that helped catch a significant correction in crude oil futures back in late March (see my "Crude's High Altitude 2B Top" from March 25 and my "Crude's 2B Top Comes To The Dailies" from April 2).

Briefly, let's take a look at the other half of Frederickson's observation, the idea that using shorter time frames can help establish a better risk-reward ratio when tracking opportunities that appear on larger time frames. With the second peak on August 2, a negative divergence sell signal would have been generated at 1485 (rounded down from 1485.50), with an initial stop just above the high of the day the signal was generated. That day, of course, was August 2 and that high was 1505.

The signal would have been triggered with the trading on August 3 between 8-9 am. At the close on that entry day, CCU5 was at 1491, and the trade was six points out of the money, so to speak. On August 4, CCU5 opened at 1495, rallied as high as 1502, and finished the day at 1479. The position has been in the money ever since.

David Penn

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

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