Cotton Traders Analysis
April 13, 2006
“The May /July Spread continues to be the focus”
But first off, some additional comments regarding; “The Funds are the new Fundamental in Cotton”
The increasing impact of funds has been dramatic and is slated to continue. According to Barclays Capital, money placed in index-linked commodity funds will rise by 38% this year to $140 billion. The Goldman Sachs Commodity Index alone has risen from about $5 billion at the start of the decade to more than $80 billion today. What began as a trickle in the early part of this decade, the investment from hedge funds, commodity index funds, and technical funds, including Commodity Trading Advisors, (CTAs), has turned into a torrent, as pension funds and endowment fund money are also allocating more of their funds into commodities.
According to one unnamed hedge fund manager attending a copper conference in Chile last week, “There is so much investment money coming into commodity markets right now that it almost does not matter what the fundamentals are doing.” That is a valid point to consider because for the most part many of these funds do not rely on traditional fundamentals (supply/demand) to initiate trades. He went on to say, “The common theme for why all these commodity prices are higher is the substantial increase in [investment] fund flow into these markets, which are not big enough to withstand the increase in funds without pushing up prices.”
Interestingly, agricultural prices, which are often seen as the laggard in the commodities sector, are also being lifted from the depressed levels of three and four years ago, with sugar prices reaching twenty year highs and orange juice futures only last week touching a 14 year peak. Thus, if technical reasons can be found for these funds sufficient to warrant the covering their current short positions and reverse into longs, cotton prices too may easily find themselves taking part in this bullish push that other markets are experiencing. Also true is the consequence of the rapid industrialization of China and India. Obviously, some investors at the start of the decade began looking again at commodities, an area that had been largely forgotten for almost two decades as an asset investment class, (index funds) as a proxy to invest in China’s growing economy as well as seeking diversification away from underperforming equities and more traditional investment vehicles. Its effect has the potential to create another boom cycle in commodity prices, as occurred 20 years ago.
This is awesome, and for the most part true, however one must understand and appreciate that the underlying concept of index funds is to acquire long positions in a style that is considered passive. In other words they tend to take positions and hold them. They may roll positions forward as delivery approaches, but index funds tend to hold positions. This is not the case with the more frequently traded funds however. They instead seek to use a system, or number crunching to determine and identify potentially profitable trades. By their nature then these funds will be more aggressive. Granted, these funds will test the consistency and profitability of conditional strategies over time and may adjust or change styles to suit a particular market. Yet these fund managers usually act frequently and on perceptions of momentum, stochastic and other technical approaches to their systematic trading.
At any rate, traders need to be aware of and more closely consider the impact that fund investments will have on an individual market and cotton is no exception. (Just look at the late trading in individual months on the close). Their approach to trading not withstanding, simply the volume these funds can wield will tend to exert a powerful influence upon prices, at times even contrary to traditionally accepted fundamentals. In other words, where as an old school trader might first view a market’s underlying fundamentals to identify the basic direction of a trend and then apply technical analysis to pick an entry and exit point at which to implement a trade, now days it makes sense to also be aware of what the funds are doing at any given point in time. The bottom line is this, funds are playing a much more major role in our cotton market and they aren’t going away.
Now as for today’s market; Prices of NY Cotton did open higher this morning. Perhaps in part due to the release of weekly export numbers reported by the USDA this morning, but more likely as the result of improved demand in the physical market stimulated by the recent drop in price. The export report showed sales of 130,000 Running Bales and shipments of 541,100 RB. The sales figure, although somewhat lower than what has been seen lately, is still above the 95,000, or so average needed to achieve the goals set by estimates. The shipment number however, is exceptional and a marketing year high, but was also pretty much expected given the pending scheduled elimination of Step 2. Therefore, while the numbers seem encouraging, they don’t offer any real surprises.
So faced with May option expiration taking place today, it was thought that prices would very well be contained between 5200 and 5300, with one perhaps eventually getting pinned, (5200). Trading in the May/July spread again seized the focus early and was interesting because it appeared as if those holding short May positions decidedly became more aggressive. In other words, those holding shorts in May were intent upon rolling those positions into July. Thus the spread which opened 165/170 came in to today first to 150. It did try to widen out from there and did get back out to 165, but then again found size offers and the differences again retreated, this time making a low of 140.
Of course once that low was established the out right market made new lows which caused the spread to widen out a little and 145/146 was traded as the closing bell rang. Settlement is another matter, as outright selling in May and buying in July took place on the close. This type of closing action has been witnessed frequently during the last couple of weeks as had been mentioned previously. Again size changed hands in the May/July spread with estimated volume of around 14,000. Expected May open interest to drop substantially today, perhaps by more than 10,000 and with FND approaching on the 24th. By late next week trading in May will become less liquid and the spread will be focused upon the setting of positions for delivery. March deliveries went into strong hands and are thought to be held in certificated stock. Will any of that cotton find its way back to the board, is the big question. If it does, will other strong hands be there to accept it, is another.
Trading in Options was slow. Key transactions included the sale of 400-500 N 54 puts, and the purchase of 100-200 N 52 puts and 100 of the same 54 puts by one floor trader. Another bought 100 N 50 puts, while still another bought 100 55/54 put spreads and 75-100 of the K 53 puts outright. The N 49 put/59 call strangle was sold at 105 100 times and K 53 puts were crossed at a price of 70.
The market will continue to search for technical information to trade off of. It is increasingly obvious that the short selling (mainly by funds) has helped to depress prices, yet as I mentioned yesterday it has always been my experience that, “prices always seek the level at which the most business can get done.” So let’s see what kind of cash market movement occurs now with prices back at the lower end of their range. If somehow technical evidence surfaces, sufficient to provide reason for those funds holding shorts to cover, and maybe even stimulate and attract funds to consider acquiring positions on the long side, then prices could move substantially higher. As a result, although the market for cotton futures appears weak and vulnerable to downside price movement, the risk reward potential being portrayed still seems to have greater potential on the plus side.
May Option expiration takes place today 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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