Cotton Traders Analysis
April 12, 2006
Plainly stated, “The Funds are the new Fundamental in Cotton”
That quote was “borrowed” from a conversation I had today with an accomplished, professional trader who happens to be located away from the trading floor. I certainly hope that they don’t mind my using it to begin today’s comments because I believe it to be especially relevant and applicable with regards to the present cotton futures market in NY, and in particular to yesterdays price action. You see, yesterday was yet another day during which prices of cotton came under pressure as the result of speculative selling pressure (thought to have been directed mainly by funds). It was that action, combined with an insufficient urge to aggressively buy, at least until prices made it into new low ground that led prices of cotton futures lower in NY trading. Once prices reached new low ground, (when May was below 5200), buying did appear, seeking to take advantage of the lower values. And importantly, the buying didn’t chase the market; rather it waited patiently as prices came to it.
For whatever reason funds continue to play an increasing role in the cotton market as they use NY futures to venture into positions that make sense for their particular style of investments. Some of these funds simply follow along a path of using the market as a tool to diversify, or supplement their market basket of raw materials, as a form of hedging portfolios, while others tend to speculate on either side of the market as they seek to profit from price moves. In either case, the magnitude of the impact these funds are having has greatly increased over the years and in particular can have dramatic effect from time to time. Yesterday was no exception.
Therefore it is crucial to admit the significant role that funds now play and the influence they may exert from time to time. This situation will likely continue what with the stock market trading somewhat flat and given the overwhelming amounts of monies that continue to search for alternative investment opportunities. The impact of fund participation is acute and it isn’t going away anytime soon. So learn to deal with it and accept it since it truly is a fundamental change from how things used to be. The treatment of the buying that was done when prices retreated below 5200 was one such example.
As I ended yesterday’s comments with the statement that “it is apparent that the July contract will take over leadership from May as the active contract with open interest being the larger in July,” so it is. Was yesterday’s action a “blow off, before prices make a turn?” Same answer, “Who knows, but getting short cotton at these levels, while other commodities are experiencing bull markets seems difficult and uncomfortable to many experienced traders. If there’s one thing that trading cotton teaches it is discipline.” I reaffirm these statements because open interest was a little surprising in that the May contract only lost a little over 6,500 contracts, while overall open interest in all months combined actually gained another 2,200. This is a surprise because it means that new selling was the feature, certainly more so than liquidation. Perhaps there was even new selling in May.
Anyway following yesterday’s action, NY cotton prices looked lower during the pre-opening and after opening prices firmed. It was kind of an inside day in terms of outright direction, after the drama of the previous two sessions. Most of the trading volume was focused upon the May/July spread. That spread opened at 178/180 and traded down initially to 161. This indicated to some that the spread has finished its work and that the redistribution of longs from May into July is starting to slow. However, that was not the case. Once the spread came in, locals holding shorts became nervous and that helped it widen once more, this time back out to 180.
Trading in the May/July spread now almost seems like a “tug of war”. The trading ring was certainly looking for differences to narrow, but they became edgy which led to it widening out again. Granted the range today was 161 to 180, although closing prices might indicate differently. Again that is solely due to the methodology used to settle the market. That rush to transact in the outright months on the close has been happening with increasing regularity during these rolling periods, which is another impact that the fund presence has had on our market. It is expected that the rolling of positions will be concluded for the most part next week at which time the focus will be upon the value in July outright and of course December. The spread between those two months will however continue to gather focus.
I should say that there are more than a few (and perhaps I should include myself among them) who simply put, “feel uncomfortable at the prospect of selling cotton short at these levels. For various reasons, among them the dry conditions in Texas, the potential for news to be reported regarding the status of the crop and …well this list goes on. This school of thought tends to believe that we are closer to a bottom than to a top and that in the long run; these price levels may in fact prove to be good values. Besides, what now with funds looking as if they are net short again, the path of least resistance seems likely to be higher. This is due to the potential impact on values that could result from speculative short covering and new buying as many of the funds regularly trading cotton are after all flexible and willing to trade either side of the market. It simply depends upon the opportunities presented for price movement.
Yesterday’s move certainly did take many by surprise. Again I am unaware of any fundamental situation that could have caused such action and therefore, point to the failure of prices to hold as stemming from weakness from a technical perspective. However, “prices always seek the level at which the most business can get done” and so it will be interesting to see what kind of cash market movement occurs now with prices back to the lower end of their range.
July will now assume its leadership role, but as mentioned earlier open interest did not come down as much as expected, especially given the large volume traded in yesterday’s session. With options expiring, a clearer picture should be available early next week and it could show a large increase in the spec net position. Fund trading has assisted the climb in open interest and it will be interesting to see how much further that level will grow. 150,000 contracts isn’t all that far away, and if prices make a serious move outside of the 5200-5500, (give or take 50 point) range, expect even that level of open interest to be surpassed.
May Option Expiration is scheduled for tomorrow since the Nybot is closed on Friday in celebration of Good Friday. First notice day for the May contract is April 24th and less than two weeks away.
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