Cocoa "mayhem" and trend following

Earlier this month, ZeroHedge, which doesn’t often post articles about soft commodities ran an article titled, “Cocoa Mayhem Sends Prices to $4,000 Per Ton, Highest Since 1978.” It mentions the poor cocoa crops in West Africa, low crop yields in Ivory Coast and Ghana, the El-Nino related weather disruptions that could further damage cocoa production, and even the inflation-driven price rises in consumer markets.

Trend followers have been long since 2022

But long before this was being discussed, and without needing to know anything at all about the crops or about El Nino, trend followers had already boarded this ride. Here’s how I-System strategies traded Cocoa over the last (nearly) five years (their performance is shown in terms of USD per Metric Ton gained or lost trading cocoa futures):

This is a busy chart, but it is instructive as it also tells the story about trend following. The top chart shows cocoa prices, overlaid with the curve showing our net exposure (how many of our 12 cocoa strategies were long or short on the scale of -12 [fully short] to +12 [fully long]).

Why do we use 12 strategies? It could be fewer, or more, but the answer is that while we formulate strategies on past data, we’ve no way to know how well any one strategy might perform in the future. By diversifying our decision making among multiple strategies that are similar but different, we reduce the likelihood of disappointments (as with the strategy shown in red) and enhance the probability of positive performance.

The testing of discipline, patience…

During four full years, cocoa prices fluctuated sideways, in a horizontal range around $2,500/MT and our strategies flatlined. In the second half of 2021 they went into a painful drawdown that lasted almost a full year before staging a gradual recovery. Here again we see that large-scale price events (LSPEs) unfold as trends that span long periods of time which is why systematic trend following reliably captures windfalls from such events. 

But the experience also shows the cost of that performance in terms of risk, drawdowns, discipline and patience which can be considerable in some cases. At its low point, in May 2022, the average strategy was down $713/MT ($7,130 per CSCE contract). With Friday’s closing (17 Nov. 2023), it was up $593. So was it even trading Cocoa worth the trouble at all? Yes, under two conditions: (1) if your business entails exposure to coca prices and you need to hedge against unfavorable price changes or (2) for portfolio diversification purposes.

Diversification: the only free lunch

For a well diversified portfolio, any one market should only represent a relatively small risk allocation. Diversification is the only free lunch in investment speculation, so it is always worth considering it whenever possible, even accepting the fact that some markets will test our patience (in fact, this is still the case with some investors’ favorites, Gold and Silver, for example). Markets do move in trends but we have no way of telling when such events might unfold, how long they would last, or how high (or how low) they might reach.

In terms of discipline, which primarily refers to the risk management, the above chart also provides some guidance in terms of gauging our risk appetite: if the average strategy could cause a $713/MT draw-down on cocoa ($7,130 per contract), what part of our total portfolio risk should that sum represent? If that sum is small enough, say 1% or 2% of the total portfolio, we need not suffer any anxiety even from long, painful drawdowns. Unfortunately, this is quite out of range of most individual investors.

However, risk can be better fine-tuned with smaller-denominated mini-contracts, CFDs and even ETFs which provide a valid proxy for exposure to cocoa prices. Adding markets like cocoa, sugar, coffee and other commodities to your portfolio should be considered also in view of the commodity super-cycle scenario which could unfold over the next decade or two. Thanks to trend following, investors can capture windfalls from future LSPEs without needing any special expertise in those markets, other than their price histories.

For investors who are so inclined, TrendCompass reports offer real time trend following signals covering over 200 different financial and commodity markets. For more information, and how to subscribe, please check I-System Trend Following | TrendCompass. One month’s ‘test drive’ is always free of charge with no strings of any sort attached.