Are We Getting Close to a Top in Cotton Futures?
Today's Idea
Although it appears that global Cotton production may rebound sharply in 2011, that will not likely help near-term demand, as Cotton supplies look to be very tight in the near-term. Trader's looking to try to pick a top in Cotton prices may want to focus on the new-crop Cotton contracts, starting with the December 2011 contract. Given the potential for extreme volatility in outright futures positions, especially as we approach the widely anticipated USDA prospective plantings report at the end of March, longer-term bearish traders may wish to explore the purchase of a bear put spread in December 2011 Cotton futures options. For example, with December Cotton futures trading at 115.24 as of this writing, a December Cotton 105 put could be bought and a December Cotton 95 put sold for about 4.50 points, or $2,250 per spread, not including commissions. The premium paid for the spread would be the maximum potential risk on the trade, with a potential profit of $5,000 minus the premium paid which would be realized if December Cotton is trading below 95.00 at option expiration in November.
Fundamentals
Any commodity market where one has to go back in time to the U.S. Civil War to find higher prices has to be considered one of the classic bull markets in recent history. The market in question is the Cotton futures market, where prices are now trading at highs not seen since the 1860"s! The Cotton bull market was a "perfect storm" of lower than expected supplies, as production from the U.S., Pakistan and Australia was not sufficient to meet the surging demand from Asia, and particularly from China. Though the "bullish" supply/demand equation is likely the major reason for sharply higher Cotton prices, the most recent price surge may be tied to buying by cotton mills who have been holding back on purchases in hopes of lower prices, but who are now being forced to "pay up" to obtain needed inventory. In addition, first notice day for March Cotton is fast approaching, with few willing sellers among commercial interests. Those caught short March Cotton may be forced to aggressively bid-up prices to draw out sellers as delivery approaches. With Cotton demand expected to remain robust this year, new-crop December Cotton prices have also moved steadily above the $1 per pound level, as prices must be competitive to compete for acreage with Soybeans and Wheat. Internationally, Cotton production is expected to increase this year, with sharply higher Cotton planting estimates coming in from China and Brazil, and potentially the U.S. ,The Cotton market is once again validating the old trading adage that "the cure for high prices is high prices,," meaning that if there is an economic incentive to do so, producers will increase production sufficiently to meet demand. So unless Mother Nature has other plans, we should see sharply higher Cotton production later this year, which may finally put an end to this historic bull market.
Technical Notes
Looking at the daily chart for December Cotton, we first notice what appears to be a potential reversal day on Thursday, as the market made a new-contract high only to close lower on the day. Though the near-term March futures did close below the previous day's lows and at the low of the day, December Cotton staged a moderate late session rally, most likely due to liquidation of bull spreads that kept prices above the day's lows. Should we see long-liquidation selling begin to occur, we could see the December futures test major support at the 20-day moving average, currently near the 108.00 area. The 14-day RSI also failed to make a new high reading on Thursday, setting-up a potential bearish divergence in this momentum indicator. Thursday's high of 120.48 will now act as resistance for the December futures.
Mike Zarembski, Senior Commodity Analyst
