NY futures continued to trade sideways since our last report of two weeks ago, with March advancing 111 points to close at 73.35 cents.
Although NY futures traded slightly higher this week, they remained well within the boundaries of a narrow 6 1/2-month trading range, in which the March contract has moved no lower than 66.85 cents and no higher than 78.02 cents. This tight range of a little over 11 cents stands in stark contrast to the historic 150 cents swing that preceded it.
It feels like the life is being sucked out of the cotton market at the moment and a look at the chart shows just how weak its pulse has become. Since the end of June the trading range in March has narrowed to 823 points and over the last five weeks is got reduced to a mere 426 points. The lack of direction and momentum has led to an implosion of volatility, with the spot month now showing a reading of less than 21%, whereas it was still close to 30% about two months ago. This is good news for anyone who needs protection for his position, because options premiums have become very affordable. For example, the March 70 puts traded today as low as 115 points.
Open interest continues to fall as well, as traders will sooner or later lose their appetite for these range-bound markets. Exactly a month ago, on October 29, total open interest in futures had reached a 20-month high of 208’031 contracts, but it has since fallen precipitously and amounted to just 161’790 contracts as of this morning, the lowest level since January 20. The drop in open interest is even more pronounced when we look at the CFTC report, which includes futures as well as ‘delta’ positions in options. On October 30, the combined open interest still amounted to 321’481 contracts, whereas the most recent report as of November 20 had it at just 217’473 contracts, or about a third less! December options expiration as well as the drop in volatility had a lot to do with this shrinking participation, but be that as it may, the futures market feels rather deserted at the moment.
When we look at the breakdown of who currently owns what stake in the futures and options market, we have small and large speculators with a 0.55 million bales net short (5.81 million bales long vs. 6.36 million bales short), while the trade was 6.32 million bales net short (4.38 million bales long vs. 10.70 million short). On the opposite side of these trade and spec shorts we have index traders with a corresponding 6.87 million bales net long position.
In order to anticipate the market’s next move, we need to figure out what these market participants are likely going to do with their positions. Starting with index traders, which are the most predictable, we are probably going to see an increase in their net long position by an estimated 7’000-8’000 contracts due to the annual index rebalancing, which takes effect in early January.
Speculators are a lot more fickle and given that we are in the middle of a 6-month sideways trend, with specs owning more or less an equal amount of longs and shorts, we could see a reaction in either direction, although the shorts seem be the more trigger-happy lot, while many longs are part of the “commodity super bull” crowd that subscribes to a longer term view.
The trade (merchants, growers and mills) has probably the most weight in determining the market’s next move. At the moment the trade is 6.32 million bales net short, most of which are hedges against unsold long positions in physicals. However, if we do the math we can easily come to the conclusion that the trade is currently ‘underhedged’. Just in the US alone we have nearly 10 million bales still for sale, if we figure supply at 21.3 million bales (3.3 beginning stocks and a bigger than expected crop of 18.0) minus current commitments of 11.3 million bales (7.8 exports and 3.5 domestic). In addition to that there are various current and new crop positions in other origins that typically use futures and options for downside protection, like Australia or Brazil, just to name a few.
In other words, the 6.32 million bales net short only covers part of the many bales that are still available for sale around the globe. However, traders seem reluctant to add to their short futures positions near 70 cents for a variety of reasons: 1) Cotton is relatively cheap compared to other commodities and will likely lose a substantial amount of acres next season, hence cotton doesn’t really need to get any cheaper. 2) China keeps absorbing supplies from the rest of the world at a higher rate than common sense would dictate. 3) Although global stocks are plentiful, not all stocks are equal, meaning that the amount of cheap inventory is relatively limited, with plenty of buyers waiting to buy it on dips.
So where do we go from here? In light of several good export sales reports and continued interest for US styles as well as other origins, most traders don’t perceive there to be any great downside risk at the moment. As long as China and some of the other importers keep buying at the rate they are, crop pressure is not likely to become burdensome, which may allow the market to stay in its current equilibrium. However, selling pressure could develop if Chinese import demand suddenly slows down and India becomes more aggressive on the export front, which could prompt US traders to put on additional hedges. On the other hand, continued Chinese buying coupled with an outlook for a substantial drop in acreage may embolden an increasing number of traders to approach the market from the long side as we head into 2013. For now the market seems to remain stuck between these scenarios and it will take considerable force to get it out of its current trading range.
The above is an opinion and should be taken as such. Plexus cannot accept responsibility for its accuracy or otherwise.