Cotton May be Close to Peaking

Cotton prices have been a prime benefactor of growing world economies and overseas demand. Since a post-harvest low back in October, cotton prices have rallied by nearly 30% (see “Cotton cruises,” below). This has helped inflate call option premiums in the cotton market nicely. 

But with spring approaching, a not-so-bullish supply outlook taking shape, and now at least the possibility of import tariffs on U.S. cotton from some nations, cotton prices could soon be facing headwinds. Fundamentally, it’s what we would deem a solid set-up for a short position, but given the springtime seasonals, it’s a better call selling opportunity. 

Springtime Seasonals Favor Bears

Seasonal price tendencies can play a big role in agricultural price forecasting. U.S. agricultural markets have historically tended to strengthen during springtime. This is largely due to the fact that U.S. planting takes place in the spring. Uncertainty over acreage and weather have historically tended to create anxiety in the markets, making bulls more eager to take positions, and making bears more fearful of jumping the gun on successful planting. In grains, this planting anxiety often happens in the late spring (April/May) period. Once successful planting has occurred, however, and crops are deemed safely in the ground, it is not uncommon to see prices weaken as anxiety tends to fade. 

Cotton has tended to display this same historical price cycle. However, as the majority of the U.S. cotton crop is planted in the south, planting tends to occur earlier in the year. Thus, the “planting anxiety” premium tends to build into the market earlier. But it also tends to fade earlier. Thus, historically, it is not uncommon to see cotton prices strengthen into March, only to give way to weakness into the spring and summer growing season (see “Cotton seasonals,” below).

Look at the chart in “Cotton cruises” and you can see that cotton prices appear to be tracking this seasonal tendency almost perfectly during the last 12 months. 

2018 Cotton Supplies Burdensome

The latest USDA supply numbers show U.S. cotton supplies at burdensome levels. In the 2017/18 growing cycle, U.S. ending stocks are pegged at six million bales – the highest in a decade and nearly double 2016/17 levels. The U.S. stocks-to-usage level at 33.6% is also a sharp increase from last year and the highest since 2008/09 (see “High cotton,” below). This sets a bearish backdrop for U.S. cotton prices in 2018. 

Global stocks-to-usage levels are at 73.5%, which is near multi-year highs. While the USDA is expected to lower global stocks slightly in its March 8 report, U.S. planted acreage in 2018 is expected to see a sizable increase over last year. This does not bode well for a longer-term continuation of the recent uptrend.

Cotton Play 

With both seasonal and big picture supply fundamentals appearing bearish, cotton prices should soon begin seeing some resistance to higher prices. Planting is well underway in the U.S. Delta regions. And while a spate of dry weather has brought some buying into the market, it remains very early in the season. In addition, U.S. cotton planted acreage is expected to see an increase over last year.

Any blow-backs from President Donald Trump’s plans for tariffs on foreign steel and aluminum remain to be seen. However, agriculture is a big sector of U.S. exports and could potentially become a target should other nations elect to retaliate to the tariffs. Should such tariffs occur in cotton, effects would likely create a further bearish force on cotton prices. 

U.S. weather issues, continued strong global demand and a slight lowering of global stocks could all be potentially bullish for prices. However, we feel seasonal pressures and overbearing U.S. supply will be too big of a burden to overcome. The path of greater resistance is higher.

Because there are potentially bullish fundamentals at play, a calling/selling approach is the right strategy for such a fundamental set-up. The seasonal tendencies and supply situation limit the upside, and the bullish factors should help keep premiums at desirable levels. 

Fortunately, weather-related volatility has now inflated distant call premium to attractive levels. 

The current premium for December 2018 90.00 cotton calls is in the $500 range. If December cotton is anywhere below 90¢ per pound at option expiration, the seller keeps all premium collected as profit. 

Traders can consider selling the December 90.00 cotton calls. The margin requirement is approximately $1,130. Thus, should the options expire worthless (in November) the sale would produce a roughly 44% return on equity. While you are tying capital up for a long period, current market conditions are presenting a unique opportunity and a great deal of breathing room. If our bearish fundamental outlook is correct and price declines begin in May, a great deal of profit can be realized well before expiration and could be locked in; then other strikes may be considered. 

Whether the market treks higher in the short term remains to be seen. Sellers of options don’t have to pick highs and lows in the market. They only have to pick price points of where the market shouldn’t go. Considering the current fundamentals, the strategy of selling further out out-of-the-money calls fits that criteria nicely (see “Time to sell,” below). The 90¢ call provides more than 16% upside room for further strength at a time when seasonals are hitting their peak and with broadly bearish fundamentals.