CTS Lesson 8: A Study In Cotton.

A Study In Cotton

By: Paul Brittain

One of the most exciting occurrences in the commodity markets is when the market trades at or

below historic lows. We are talking about true commodities such as grains, metals, energies, and the

softs. True commodities are products that are grown or manufactured and possess real intrinsic

value based upon supply and demand unlike currencies, stock indexes, or financials.

True commodity prices fluctuate based upon supply and demand and travel back and forth in a long

term trading range. Going from one end of the range to the other as the differential between supply

and demand changes. To see a commodities long-term range, or what I refer to as the envelope, you

use monthly charts, which should go back twenty years or more. The chart below is a monthly chart

on Cotton. Its main trading envelope is between 50 and 80 cents. There have been occasions where

the market traded beyond these prices when an abnormal disruption occurred between supply and

demand causing the prices to push to outer edges of its normal range.

Cotton Chart

It is these “abnormalities” that we are looking for because they are relatively short lived and the

market should eventually return back to its envelope. Now before you get all excited, look at the

chart carefully. Each bar represents one month and it may take as much as two to three years for the

market to adjust back

to the range.

Sometimes it

happens fast,

sometimes it doesn’t,

and the whole key to

taking advantage of

these situations is

being there when it

does happen.

Scale Trading is

based upon this type

of strategy when a

market is trading at

or near its normal

lows. Because any

natural commodity

will always have

value (the price can

never go to zero) and

a definitive cost of production, the theory is that eventually a shift will have to happen in the supply

demand relationship. This shift occurs due to economic factors involved in the production of that

particular commodity. Basically, if the price drops below the cost of production, the growers or

producers cut back the size of the crop because if they don’t they will lose money. They will usually

produce a minimal amount just in case the current over supply situation ends due usually to some

sort of natural disaster in another part of the world. Farming and speculation go hand in hand.

On the other side of the spectrum, when prices are at the high end of the range, growers and

producers will go as far as growing crops in their front yards to take advantage of the current price,

which leads to the supply catching up and satisfying the demand. That in turn will push prices back

toward the bottom of the trading envelope.

Another factor that can change the direction or current market situation is a change in government’s

economic policies. If you look on the Cotton chart during 1986, you will notice a sharp drop in the

price. This was due to the government changing their stance on the subsidies they had provided for

cotton growers since the beginning of time. It had been so long since the price of cotton had to stand

on its own two feet, nobody was quite sure where the free market price would end up, as you can

see, the market recovered. Another market that enjoys a situation similar to what cotton used to

enjoy is the US Sugar market, or Sugar #14 Domestic Sugar. Notice that it is usually two to three

times the price of Sugar #11 or World Sugar. No, you can’t buy World Sugar and sell it on the

domestic market, but thanks for asking.

Yes, it’s an ongoing, never ending cycle that makes commodity trading so much fun as well as

extremely lucrative for those who succeed in playing the moves correctly. Remember, commodity

trading is a zero sum gain, which means that for every winning trade there is a losing trade and the

actual percentage of winning traders to losing traders is about 3 out of 10 win.

Scary? You bet. But if you look at the big picture, you’ll see that most successful traders understand

that losing trades is as much a part of trading as winning trades is. Most successful traders only win

45% of their trades, but because they cut losers relatively quickly and ride the winners, they try to

maintain a win/loss ratio of 3 to 1. In other words their winners are three times bigger than their

losers, you do the math.

How can you take advantage of these market situations when they become apparent? Innumerable

ways, the key is to find a way to take advantage of the opportunity in a way that you can afford,

understand, and stick with. All three of these things are essential to being successful. One without

the other and your success probability falls greatly.

My suggestion is to set up a trading plan (in the case of cotton) using the infinite wisdom that it is

impossible to pick the bottom of a market. Instead of trying to “out trade” the market like a majority of

the traders try to do, do what the big guys do- “out last” the market. The big traders keep buying into

every dip and hold the commodity until prices become more favorable. They feel if the commodity

was a bargain at 50 cents, it’s an even better bargain at 45 cents and so on and so forth. Remember,

the price of a commodity can never drop to zero, and to big traders that’s the key. There is no Enron

here. These are goods, not bads. In the case of cotton trading at 50 cents, the most it can go against

them is $25,000 per contract even if it did go to zero.

I know, to a zillionaire 25K is nothing, a one-night stay at the penthouse of the Palms here in Vegas,

but to the rest of us it’s an uncomfortable amount to risk, never mind lose. This is where you have to

become creative without becoming crazy, brave without becoming foolhardy, and most of all

involved.

When markets enter into a situation such as cotton recently has, I look at strategies that rely heavily

on options, the good old American Style Option

The basic strategy is to just buy a call option. You pay a premium in exchange for limited risk (the

premium) and unlimited profit potential. You have staying power, you are in the market until

expiration, the market can go from where it is now all the way to zero without you being forced out for

any reason, and if you're lucky enough for the market to bounce back and go beyond the strike price

of your call enough to re-coop your option premium, you may even make a profit.

I have seen situations where a market went against an option so far that all involved just gave up

hope and wrote it off as a loss. Suddenly, it came back to life because of some sort of turn of events

and make money. Unfortunately, the number of times that this has happened pales in comparison to

what happens a majority of the time- the option expires worthless. In fact, studies have shown that

over 75% of the options end up expiring worthless.

Another strategy is to use a counter trend trade. In the case of cotton, the trend is definitely down. If

you were to buy futures contracts, you would receive margin calls as the trend continued, if you

bought a call option you would see your premium diminish due to the market moving against you and

time erosion. A counter trend strategy employs a combination of long and short calls so that if the

trend continues to go down you would benefit while taking advantage of a historic low price in that

market.

The strategy is called a “Bull Call Ratio Spread.” You would buy one call and simultaneously sell two

calls with a higher strike price. The rationale is that the premium you collect on the two calls you sold

would help pay or totally pay for the call you purchased. If the trend continues down you would

benefit by making money on the two short calls while only losing on one call. When and if the trend

reversed (which is what you were hoping for) and the market started to trade higher, you would then

need to adjust the position by either buying back one of the short calls, adding an additional long call

or even possibly a futures position to cover the exposure to risk on the upside.

The key here is the spread between the long call (primary leg) and the short calls (secondary leg).

You need to calculate your risk based upon the intrinsic math of the spread. This isn’t really that hard

to do. You take the spread between your primary and secondary options, let’s say it’s 10 basis

points, and then add the amount of the spread to your short calls. If you bought the 50/60 1X2

spread in cotton, that’s where your primary long strike price is 50. You sold two call options with a

strike price of 60, and the monies collected on the sale of these options covered the cost of the

option you purchased (excluding commission). Your “reverse” intrinsic breakeven would be 70. The

trade would have accumulated 10 points of intrinsic ($5000) value at 60 and if the market kept rising

beyond 600 the trade would be giving back the gains it accumulated at the same rate ($500 per

penny) until it ran out of money at 70. Above 70 you would experience “out of pocket” losses at $500

per penny.

Another strategy would be to use a “Bull Call Spread with a Naked Leg.” Looking at the chart above,

the idea would be to buy the 50 call and sell the 60 call and 40 put. The money collected by selling

the put and call would offset most of or possibly all of the cost of the 50-cent call. A bull call spread

has limited risk as well as limited profit potential by itself. If the market managed to get above 50

cents by expiration, your position's intrinsic value of $500, for every penny up to 60, would stop

making money because of the short 60 call. The risk of this type of trade is if the market goes down.

You know that of course if at expiration the market were below 50 you would lose whatever premium

you paid out of pocket plus commissions. If the market went below 40 cents you would experience

the same risk as if you were long the futures market risking $500 per penny that the market went

against you.

A third strategy suitable for this type of market scenario is called a “Synthetic Call,” a synthetic call is

created by going long a futures contract while simultaneously buying a put option. In the case of the

market on the chart above, let’s say you went long Cotton futures at 50 cents. You would then buy a

50-cent put, let’s say, for $1500. This type of trade has no margin requirement and it has limited risk

as well. Your risk would be the premium paid for the option, as well as whatever the spread is

between where you went long the futures and the strike price. This type of trade has unlimited profit

potential.

Basically, if the

price drops below

the cost of

production the

growers or

producers cut back

the size of the crop

because if they don’t

they will lose money.

There have been

occasions where

the market traded

beyond these prices

when an abnormal

disruption occurred

between supply and

demand causing the

prices to push to

outer edges of its

normal range.

Futures Traders Helping Future Traders