The soybean futures market at the CBOT has rallied $3.50 per bushel in the past four months. This strength may have come as a surprise to some market participants, given U.S. soybean ending stocks have increased in each of the past two years. However, astute chart readers were led to believe that something was up in the soybean market when they anticipated the development of a bear trap.
Bear trap
A bear trap takes time to develop, as it will generally form over a couple of months or more. The bear trap that materialized at the harvest lows in 2006 was completed in two months. The recent bear trap in the soybean market took eight months to form.
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At first, a market is found to be trading sideways in a rectangular pattern, within a well-defined area of resistance and support. An example of this is illustrated in the accompanying chart. Horizontal line (R) is drawn at $10.60 which defines overhead resistance and horizontal line (S) is support at $9.20.
For almost a year, the market was in equilibrium, trading in a $1.40 range between $9.20 and $10.60. After an extended period of time, the market broke down from this sideways pattern. With support breached at $9.20, the news became incredibly bearish and the market fell into a new lower trading range.
A new area of support developed at $8.60 and from September 2015 until March 2016 the market traded a sideways range between $8.60 and $9.20. In April 2016, the market pushed through resistance at $9.20. This sprung the trap shut, and caught the bears off guard as their short positions were losing money.
Increasing open interest indicated fresh buying accompanied the short covering and the subsequent rally pushed futures prices beyond the upper boundary of the rectangular pattern (R) $10.60. The measurement from the rectangular pattern indicated the soybean market would rally to at least $12 per bushel and this objective was achieved on June 10, 2016.
This measurement is derived from taking the height of the rectangle and adding it to the breakout point. $10.60 – $9.20 = $1.40. $10.60 + $1.40 = $12.
Market psychology
As the name implies, a bear trap catches the shorts looking down at the bottom of the market. The trap is set when futures break below the lower boundary of a rectangular pattern. At first, the outlook for lower prices has the bears feeling confident about their short positions. The ensuing bearish news substantiates the shorts adding to their profitable positions and is encouraging new shorts to enter the market.
With the market trading at a new lower level and the outlook for further weakness, what could possibly go wrong?
Well everything, if the market trades back up above (S) $9.20, as it did. At first there may be a lack of bullish news to explain the sudden surge in prices, so the shorts might be reluctant to exit the market. This turned out to be a big mistake.
The shorts began hemorrhaging money, and as they scrambled to cover (buy back) their positions, the market was propelled higher. This alone was enough to drive prices up, but new longs entering the market added additional fuel to the fire.
The last time I saw this occur was in October 2006. Fourteen months later, the soybean market was at a new historical high, surpassing the previous record high of $12.90 in June 1973.
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