Cotton Conundrum
Fundamentals
Volatility has returned to the Cotton futures market of late, as traders turn their focus to weather forecasts early in the growing season. Cotton prices had fallen to 8-week lows as unexpected rainfall occurred over the West Texas growing region last weekend, which did wonders to improve growing conditions there. This decline comes after an over 15 cent rally in December Cotton from its March lows as a weaker U.S. Dollar and better-than-expected export business had speculators in a buying mood. Going forward, traders will continue to focus on the weather especially in Texas, as any signs that hot dry weather will return to this key growing region could impact Cotton yields and force analysts to lower U.S. cotton production. The USDA has already lowered its estimate for 2009-10 world Cotton carryover to 56.54 million metric tons (mmt), down from 61.16 mmt for the 2008-09 marketing year. Besides the weather, the wildcard for Cotton will be Chinese demand next season. So far this year, Chinese Cotton exports have been brisk, but there are questions on whether this is due to a general restocking of commodities in general or due to increased usage. If the former, then Chinese buying may diminish later this year and current upwardly revised export totals may be too high. This could cause new crop Cotton prices to fall, especially if U.S. production rebounds.
Trading Ideas
Given both bullish and bearish arguments for Cotton prices have merit and an entire growing season is ahead of us, traders may wish to explore trading strategies that are direction-neutral but will benefit from increased volatility. One such trading strategy is buying Cotton strangles. An example of such a trade is buying the December Cotton 60 calls and buying the December Cotton 50 puts. With December Cotton trading at 55.10 the strangle could be purchased for 6.15 points or $3075 per strangle, not including commissions. The premium paid is the maximum risk on the trade and the trade will be profitable if December Cotton is trading above 66.15 or below 43.85 at option expiration in November. However, many traders will look to exit the trade if volatility increases sharply well before expiration or Cotton makes a sharp directional move quickly to limit the effects of time decay on the position as expiration approaches.
Technicals
Looking at the daily chart for December Cotton, we notice what may be a flag formation forming. This formation is usually a consolidation pattern that tends to resolve itself in the direction of the current trend, which is up. Prices are just above the 100-day moving average but the market failed in its attempt to move above the 20-day MA last week. Prices have made a 50% Fibonacci retracement from the March lows to the May highs and found a bit of bargain hunting buyers near the lows on Monday. Volume has increased sharply in the December contract, as traders have begun rolling out of the July futures ahead of first notice day on June 24th. The most recent Commitment of Traders report shows both large and small speculators net-long Cotton futures but have curtailed the positions somewhat during the recent price correction. This leaves room for additional contracts to be added should prices break out of the current flag formation. Support for December is seen at 52.90, with resistance found at the recent highs of 61.69 made on June 12th.
Mike Zarembski, Senior Commodity Analyst
