Cotton Rally Plumps Premiums for Call Sellers
With Call Premiums Now Inflated, the Bullish Story in Cotton may be Running out of Steam
By: James Cordier, OptionSellers.com
In The Complete Guide to Option Selling, you’ll learn that one of the highest probability trades in option selling is writing options in favor of the trend.
That being said, writing options against the trend can be a good way to pull high premiums from distant out of the money strikes. This is especially true with trends that may be reaching points of fundamental exhaustion.
Such could be the current case in the Cotton market.
Cotton prices have enjoyed a yearlong bull market – largely the result of lower production and expectations of increasing global demand. But there comes a point where bullish fundamentals get priced into the market. When those fundamentals stop getting more bullish, it can mean an inflection point for a bullish trend.
Cotton prices could be approaching that cusp now. Option sellers aren’t in the business of picking tops or bottoms. But the current price of cotton, combined with the availability of distant call strikes makes this a good time to start taking call premium far above current underlying price levels. This in anticipation of changing fundamentals.
More interesting from a timing perspective is the latest commitment of traders report showing Non-Commercial (read Speculator) long positions at 132,318 contracts – an all-time record long position. This makes cotton prices vulnerable to a potentially harsh liquidation phase should non-bullish news start to take root.
Surge in Cotton Demand
Cotton prices have trekked steadily higher over the past year as the 4th straight year of lackluster US production finally met a surge in renewed economic optimism. This new wave of optimism – enhanced by the November US election result has resulted in expanded demand for cotton. Indeed, 2016 global cotton demand hit its highest levels since 2010. And that demand has not slowed as of yet. The latest USDA export sales report shows US cotton exports at 95.9% of the USDA estimate vs. 88.9% on average for this time over the last 5 years.
But the market has spent the better part of the last 12 months pricing increased demand. And supply side fundamentals are beginning to shift.
Bull May be Tiring
Increased demand notwithstanding, supply side fundamentals may not be as bullish as would be expected by looking at prices. 2016/17 US Cotton Ending stocks, while adjusted lower from February’s estimates, are still the highest in 8 years at 4.5 million bales. US cotton stocks to usage ratio is expected to hit 27.3% for 2016/17 crop year -the second highest in 8 years
US Cotton 2016/17 Ending Stocks are projected to hit 8 year highs.
For a brief explanation of the critical importance of Ending Stocks and Stocks to Usage Ratios in Agricultural Markets, watch our brief tutorial here.
Market Eyes Fresh Supply
While current supply is important, it is the upcoming US crop on which prices will soon begin to place their focus. Because prices have risen significantly, US farmers are reacting by planning higher US cotton acreage this spring. As per the National Cotton Council, US farmers will plant 11.017 million acres of cotton this year – 9.4% more than in 2016. While this could turn out to be at least a drag on the bull cause, it is the markets historical reaction to planting season itself that could make call selling a winning play this Spring.
Cotton Seasonal Tendency
Cotton prices have historically had a bearish reaction to the beginning of planting season. As cotton planting gets widely underway in April, the market turns its focus towards new crop cotton. Because cotton is planted primarily in more southern regions of the US, frost scares are less of a concern than in northerly planted crops such as corn or soybeans. Thus, as the crop goes “in the ground,” the market already begins to anticipate the new supply of autumn harvest.
Historically, this has tended to (although not always) weaken cotton prices from Spring through early summer. This seasonal tendency is reflected in the chart below.
Cotton prices have historically begun to decline in the Spring as the market begins to anticipate new crop supplies as planting progresses.
Conclusion and Strategy
While we’re not calling a top in the cotton market (option sellers don’t have to do that), our research indicates that the bull market in cotton may be nearing a point of fundamental exhaustion. With 16/17 US ending stocks are not burdensome on a relative scale, they are the highest in 8 years. More importantly, we have reached a time of year when the market begins to focus on the new crop. With 9.4% more acreage intended for planting in 2017 as was planted in 2016, planting season should not be a bullish development for prices.
Should a typical seasonal price pattern take hold this Spring – call premiums at today’s values will look extremely overvalued in hindsight.
The long bull market has inflated call premium at strikes nearly 20% above todays market price.
We’ll be looking to potentially target an array of strikes and strategies in managed portfolios this month should cotton continue to trek higher into April.
Those wishing to attempt the trade on their own can consider selling the December Cotton .90 call option for premiums of $450 -$500 +. Margin requirement per option is approximately $1070 each.
December 2017 Cotton
Selling the December Cotton .90 call option
Selling options this far above the market allows you to position for sideways or lower prices later without trying to pick an absolute top in prices now. It also gives you plenty of room to be wrong (to some extent) and still come out of the trade with a profit.
The risk, of course, is that prices surge another 20% right up through the growing season – forcing you out of your option at a loss. While a losing trade is always a possibility, we believe an additional price surge of 20% is highly unlikely into planting season.
Stacking all available odds in your favor is what option selling is about. They seem to be tilting that way for cotton call sellers now.
James Cordier is founder and head trader of OptionSellers.com, a US based wealth management firm specializing exclusively in option writing portfolios for high net worth investors. His latest book, The Complete Guide to Option Selling 3rd Edition, is available in bookstores now.
For more information on managed option selling accounts with James Cordier and OptionSellers.com, visit www.OptionSellers.com/Discoveryfor a FREE New Account Information and Discovery Pack.