The Touch, The Feel of Trading Cotton Spreads

Cotton is one of the oldest commodities in the world. The New York Cotton Exchange was founded in 1870, about 22 years after the Chicago Board of Trade. Now, cotton trades on The Ice.

Cotton prices have been soaring the past several weeks. That means that you’re either jumping up and clicking your heels or you’re banging your head against the wall because you’re not in the trade.

Today, we’re going to look at a spread trade in cotton. This is called an intra-commodity trade because it involves 2 cotton contracts. Later this week, we’ll look at an inter-commodity spread between 2 different commodity contracts. Spreads can be looked at as relative value trades because you’re not looking at one contract to go up or down, but the relationship between the two contracts, that is, the price of the spread is the price of one contract relative to the other.

The two contracts we’ll look at are the March and October of 2011 – highlighted in red below.

CT = ticker for Cotton
H = ticker symbol for month of March; V = ticker symbol for October
1 = indicates we’re looking for 2011 (not 0, or this year 2010)

CT H1 minus the price of CT V1 = spread

Click for larger image

Cotton, as a market, is said to be in backwardation. That means that the prices are higher for the nearer contracts and lower for the deferred contracts. That says to the market that cotton is in high demand. “Give us all you have right now, and don’t store anything.” In fact, you can look at the prices in the “future” being lower as a penalty for holding anything in storage. The market is paying a premium for cotton and penalizing producers by delivering it later.

Here is the current chart for the March/October spread. Like the December 2010 or the March 2011 contracts themselves, the spread chart has gone parabolic:

Click for larger image

In order to have profited from this price relationship, you would have had to have purchased the March and sold the October against it. To take profits you’d have to sell the March and buy the October’s back.

But what does the rest of the spread look like as we approach the end of the year?

We’ll get to that, but first please enjoy this brief video about cotton:

Based on the last 4 years, it looks as if the trend of the spread has peaked or is close to peaking. The 178 day correlations look amazingly close. Notice that we’re at multi-year highs in the cotton, yet the spread has been acting this way for years. You don’t have these opportunities to trade or to hedge with equities.

Click for larger image

Or you can click to download the cotton spread chart.

In order to avoid the seasonal downdraft that has been the norm in cotton for the last 4 years, you’d have to unwind the spread in the manner that I described above.

In order to trade the spread to narrow, ie decrease in relative value, you would sell the March and buy the October.

Trade at your own risk. Spreads can be less risky, and afford you lower margin. HOWEVER, you can be wrong on both legs as your short can rage higher and your long can go lower.

Cotton spread chart from Moore Research. Used with permission from Moore Research. MRCI is offering a free 2-week trial subscription.