Does Friday’s Reversal Signal an End to the Cotton Bull Run?
Fundamentals
Cotton traders had to be feeling a bit of whiplash after Friday’s trade saw prices move to historic highs on the opening, only to end the session down the extended 500-point limit, as speculators stampeded to the exits as the U.S. Dollar rallied, causing a sell-off across the commodities sector. Fundamentally, the outlook for stronger Cotton prices remains in force, as crops in both China and Pakistan have been hard hit by excessive rains that have wiped out a significant portion of this season’s Cotton production. Chinese demand has not been curtailed significantly, despite record prices, adding to traders’ fears of possible shortages later in the year. The high prices of Cotton are needed to provide incentives for U.S. producers to expand acreage next season, which will be desperately needed to help meet current demands. However, the expected tight carry-over inventories for both Corn and Soybeans have raised prices in these markets as well, giving producers several options for planting next season. This competition for acreage could force Cotton prices even higher in order to win some of the “swing acreage”. Technically, however, Cotton prices appeared “overbought,” with the widely watched 14-day RSI displaying a potential bearish divergence. Friday’s rally hit a historic high of 119.80 before selling entered the market, triggering a slew of sell-stops resting just below yesterday’s highs of114.87. The selling pressure sent buyers to the sidelines, causing prices to fall by the expanded 500-point limit, which is where prices ended at the close. Although it is still too early to call this a top in the Cotton market, the key reversal seen on Friday definitely dampened the spirits of the bulls, and follow-through long liquidation is likely, as weak longs need to be taken out of the market in order to restore health to the bull market.
Trading Ideas
With a potential key reversal on Friday, it may be very difficult for those holding long positions in Cotton to maintain their holdings should the market be in the midst of a significant price correction, despite continued bullish fundamentals. Those holding long futures positions may wish to explore buying a collar using Cotton options. This strategy involves buying a put and selling a call in the same contract month. For example, with December Cotton trading at 109.87 as of this writing, a trader long December Cotton may choose to purchase a 103 put and sell a 125 call. As of Friday’s close, this trade could have been done for about a 100 points, or $500 per collar. The put leg of the trade can act as a stop should pries continue to plunge. The call option is sold to offset some of the premium paid for the put, but also caps the potential upside gains to the call strike price.
Technicals
Looking at the daily chart for December Cotton, we notice the bearish engulfing pattern formed on Friday. This pattern in Japanese candlestick charting typically signals a continuation of the new bearish trend. This reversal on high volume could spur further selling when long liquidation sell stops are triggered as prices move lower. Although there is some support at the 20-day moving average near the 103.30 area, major chart support is not seen until the 95.00 area. The bull trend will not resume until the Friday highs near 120.00 are taken-out on a closing basis.
Mike Zarembski, Senior Commodity Analyst
