Trend Followers Cuckoo for Cocoa Puffs

We half-jokingly know that as soon as we post this, Cocoa will sell off 10% to 20%…. but it’s time we weigh in on the marvelous trend happening in the Cocoa Market, leaving many trend followers as happy as that bird on the cereal box:

 

A Textbook Up Trend

Here’s the beautiful chart courtesy of FinViz, showing Cocoa futures going from around $2,500 per ton at the beginning of 2023 to nearly $6,000 per ton:

And here’s the chart from SocGen’s Trend Indicator showing a simple moving average cross-over trend following system going long Cocoa back on November 17, 2022 – 460+ days ago. Trend models didn’t know the breakout was going to be more than a year long. Trend followers didn’t know there would be a poor growing season. Trend followers simply watch the price and get in when an up trend is signaled (in this example when the fast-moving average crosses over the slow-moving average).  We should note, trend followers will do this every time. They will get into dozens of false breakouts that don’t turn into beautiful trends like this one, in order to ensure when the ‘big one’ comes, they are in the trade. This creates a sort of option buying profile where trend models take lots of small losses (like buying premium), to eventually get an outsized gain.

What’s going on? 

Well, Cocoa as you probably know is used in making chocolate. And the world loves it some chocolate, with demand there as high as it’s ever been. The majority of the world’s cocoa is grown in Western Africa, mainly Cote d’Ivoire and Ghana. This concentration creates political risks that influence the global cocoa market. About 60% of global cocoa production hinges on conditions within these relatively small growing regions. Of course,  Trend Followers don’t much care why the market is rallying, but depending on your news source the reasons are El Nino and warmer growing conditions in Africa, decades of underdevelopment in crop production, or those nasty hedge funds driving up prices….

Cocoa Prices Surge to Record Highs as Cocoa Output Sinks in Ghana

The Bittersweet Truth Behind Surging Chocolate Prices

Hedge fund stampede into cocoa futures fuels record price jump

Speaking of those nasty hedge funds (read trend followers), we’ll continue to say we never get a thank you note when prices are down and trend followers are short a market. No. It’s only blame when prices are up.

 

The Mechanics

We don’t often get into the weeds on just what a trade like this looks like on the back end, so will explain a bit here. Using the above example of a simple trend following mode going long on Nov. 17, 2022, let’s assume the model was being traded with $1,000,000 and a risk per trade of 0.50%, equalling a risk budget of  $5,000 for the trade. Now, each cocoa futures contract represents 10 metric tons of deliverable cocoa beans, so each $1 per ton move in the futures contract price equals $10 of profit or loss. The risk on the moving average cross-over trade is the distance from the price to the slow-moving average, which we’ll call for the sake of easy math $100/ton (roughly $2,300 price down to $2,200 slow-moving average). That represents a potential loss on the trade of $1,000 per contract ($100/ton times 10 tons per contract). Now, our risk budget was $5,000, so this trend trade would end up doing 5 contracts ($5,000 risk budget / $1,000 risk on the trade).  Trend followers normalize their exposure to each market and each trend by using a sort of risk budget system like this. So that a 25% upmove in Cocoa returns a similar amount at the portfolio as a 25% move in Crude Oil.

Ok, so our example trend trade would go long 5 contracts of Cocoa at a price of $2,300, representing 50 tons of Cocoa and a total nominal investment of $115,000. However remember in futures, you simply have to have a ‘performance bond’ equal to a percentage of that amount. For easy math again, let’s say the margin was $3,000 per contract at the time of the long entry, meaning the trend follower needs to have $15,000 in the account to (here’s more on how there’s a required minimum needed to trade and the minimum most trend followers ask investors to have in their account).  So, fast forward to a current price of around $5,800 per ton. That’s a total value of $290,000 for our 5 contracts for 50 tons of Cocoa exposure, meaning this trend trade would be sitting on profits of $175,000 – which let’s call $170,000 to account for slippage and commissions and the roll costs between futures contracts over that year+.  That’s a gain of 1,133% on the small amount of margin needed to place the trade, 148% on the initial nominal investment of $115,000, and 17% at the portfolio level assuming that $1 million trend model trading level. Past performance is not indicative of future results, and nobody in their right mind should or would do this trade with just that minimum margin requirement.

But that’s how a trend trade works behind the scenes, turning a small bet of 0.50% of total capital into a gain of 17%, and turning normal quant nerds Cuckoo for Cocoa puffs.

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