August 15, 2013
The cotton market reflects high price risk. China holds 62% of worlds stocks, but uses only 33%. Therefore, China’s cotton policy decisions drive the international cotton market rather than supply and demand.
Heavy speculative trading is also a concern because speculators can move futures prices several cents up or down at any time.
However, in the U.S., 2013 projections by USDA reduced production due to low yields to 13.1 million bales, compared to 17.3 million last season.
The Texas crop is extremely poor. The August USDA report projected a Texas crop of only 4.1 million bales, compared to a 2012 crop of 5.0 million. As of August 12th, the crop condition was 20% poor, 16% very poor, 33% fair, 26% good, and 5% excellent. Top soil moisture condition statewide was 76% very short to short. The state’s cotton abandonment rate will likely be around 40%.
Consequently, U.S. stocks are tight. With rest-of-the-world (ROW) stocks limited, many foreign countries are interested in buying U.S. cotton. Although the U.S. futures market has remained fairly strong, in the mid-eighty cent level, it has reached the 92-cent resistance level in mid-August.
Because the threat of lower prices is real, producers need to consider protecting against a sudden reduction in China stockpiling cotton. During price rallies, consider selling cash cotton and buying futures calls next May or July. The calls generally cost less than holding cotton in storage.
For example, on August 14th, a July 14 call strike price at 96 cents costs about 3 cents per pound. Yes, that seems expensive, but holding cotton in storage is too.
If you understand implications of options spreads, you could buy a 94-cent July 14 call for 3.50 cents, and sell a July 14 104 call for 1.62 cents and have a net cost of about 2 cents. Thus, your top price could reach 104 cents per pound.
For some 2 cents you could protect against a 10-cent increase in July 14 futures price. Take your pick--a simple July 14 94 call for 3.5 cents or a 94 to 104 call spread for 2 cents.
Given the high risk of adverse futures price moves, try to fix a floor under your cash cotton in the low 90 cent or high 80 cent range.