Livestock producers were left scratching their heads when the December 2011 soybean meal futures contract posted a new high in late August. The news was incredibly bullish, as concerns of an early frost were on producers minds.
The big question was, Should I be locking in the price of meal before it gets any higher? As always, I turn to the charts in search of an answer.
The first observation I made, was that prices had been trading in a sideways range for an extended period of time. This is referred to as a rectangular pattern with the price of meal contained between an area of resistance at $370 and an area of support at $330.
The second observation was that prices broke out above $370 on August 23, 2011, which led me to question whether this was a false breakout above the line of resistance.
Back in the 1980s, one could rely on prices to have follow-through strength after a breakout from a rectangular pattern, as seen in the accompanying chart. During that time, you could expect prices to advance the height of the area defining the rectangle. If the range was $40 per ton, as seen in the chart, you could count on a $40 rally following the breakout but not so in this day and age.
This is because things have changed with the advent of the large speculative funds. They build massive positions and have to be careful not to pressure the markets too hard when they are liquidating their long positions.
What better opportunity to offload their huge long position, than by selling when there is a flurry of buying activity, such as when prices break out of a well-established sideways trading range?
On the breakout, the shorts were buying back their losing positions, longs were adding to their already profitable positions, and other traders were initiating new long positions. Buy stops were triggered above $370, which magnified the buying frenzy.
A surge in volume and open interest was a telltale sign of the increased buying interest. This is when the news was incredibly bullish to substantiate the higher prices. Fears of frost and escalating prices were enough to cause even the most disciplined livestock producer to entertain the idea of locking in meal before the price went even higher.
By recognizing the fact that rectangular chart patterns are often associated with false breakouts, you can avoid getting caught up in a buying frenzy. Armed with this powerful information, wise market watchers search for reasons to look away from the crowd.
Looking at our soybean meal futures chart you can see that on August 31, 2011, a reversal pattern called a harami (sell signal) materialized on the candlestick chart, at the peak of the market. Prices then turned down below $370, confirming the false breakout. From there, prices collapsed. The free fall didnt let up until meal lost $90 per ton; dropping from $391 on August 31, 2011 to $301 on October 7, 2011.
Every livestock producer I know can certainly benefit from a $90 drop in the price of meal. Oh, and the frost. It did occur, but this turned out to be a case of Buy the rumour sell the fact. This simply means that the frost had already been factored into the market by way of higher prices, so once the frost materialized, prices collapsed.
By understanding chart patterns, and the psychology of the marketplace, one is less likely to get caught buying at the highs.
The fund managers understand this concept and this is why you often see them selling at the top and buying at the bottom when the masses are looking the other way.
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