The divergence in the cocoa market is often the subject of talks. And there is no wonder why. Such a strong anomaly cannot be often seen. Particularly, I mean the divergence between the structure of the market (term structure) and the price of cocoa. I have pointed at it several times in the Spread report and in our Spread Facebook group.
What exactly we are talking about?
Interdelivery spreads can often tell us what’s going on behind the market. And that’s a great thing. Let’s look at cocoa. Almost since the beginning of the year, it has been moving to the side. Therefore, we cannot learn much from the price of the underlying asset.
Let’s look at the move of the nearest bull spread CCZ17-CCH18. At first, the bull spread was normal. This means that its move was positively correlated with the movement of the spread´s closer leg price, which is the December contract. This is a normal phenomenon that is common and we do not read anything special out of it.
But we can see significant changes from the beginning of August. Bull spread went up sharply, despite the drop of the underlying asset´s price. But that’s not all. Bull spread is growing even though the market is still in contango (bull spread is negative). And that’s very strange. Contango usually acts against bull spreads. It is a clear indication that there is something else on the market that we cannot yet see based on the price of the underlying asset.
So what’s going on behind the market?
When the bull spread is rising and the price of the underlying asset is going down at the same time, it means that the closer contract goes down more slowly. Which should be exactly the opposite, as the closer contract should decrease faster because it is usually more sensitive to the current market situation. However in the case of divergence, an invisible factor is present and it slows down the decline of the term´s structure closer part. For example, this resistance is caused often by a gradually increasing demand for commodities with the closest delivery date. Or, there may be some other change in the market, which was not yet visible on the price of the underlying asset.
It is often the case that such divergence signifies the upcoming rising price of the commodity. Due to persisting conditions, when market is oversold for a long time, growth is likely to be relatively high. Of course, again, nothing is 100 percent. Market consolidation can calmly continue for months.
Spreads once again proved to me that they can better reflect the real physical market condition and they can well filter the external influences. For long time, I have been expecting the cocoa growth based on COT analysis. Even though we are not there yet, the spread traders could already enjoy it. I was also holding the bull spread on the cocoa, but I had to get out long time ago. But I know few of my students and colleagues that are still holding bull spreads and they have nice profits.