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A Carefully Long Cotton Futures Trade
Cotton Futures has broken over a resistance level not broken since 2011, and we are expecting this to follow through to the upside. We are expecting the next leg up to take cotton well over the 2018 highs by early September. At that stage we might be looking at a large retracement on cotton but we’ll have to wait and see. Bloomberg Sugar Index Weekly Chart:
In the short term cotton futures is likely going to be retracing for a couple of weeks, and there is some potential for that retracement to be as much as 20% if the double top setup on the chart below should play out to target. We think that is possible but unlikely. At that retracement low we are planning to wait for a setup and go long, but in the meantime Matt has come up with a clever way to put on our first long leg. CT Jul 60min chart:
Cotton Futures Options Strategy
We are looking for a rise in the spot price of Cotton futures to around the $100 level by early September. This is a current trade opened on the 11th June with the December future trading at 0.9196. The current spot price of Cotton is around $94 so it should be noted that the December future is trading a quite a discount to the spot price. This has been taken into account when setting up our futures options position.
1×2 ratio call spread
We have opened a 1×2 ratio call spread in cotton in the Aug/Dec series of Cotton futures options. We are long the $94 call and short 2 of the $100 calls. We feel overall bullish on Cotton but consensus was that it could dip a little first before going higher.
By constructing a ratio spread using carefully chosen strikes we were able to create a negative delta on the spread. This works to make us initially short Cotton so any small dip in its price would be profitable. Over time the spread will flip and have a positive delta leaving us long Cotton hopefully into our target of $100.
It also has the benefit of being set up for a credit (-0.0054) meaning that should we be completely wrong and Cotton were to go straight down from here, the trade would still be profitable as we will collect the full premium received at inception.
Our risk is above $106 (spot) at expiry and we do carry some risk above $100 in the near term although we deem the chances of such a swift rise as unlikely. The timing of futures options trades is very important for this reason. An even greater return can be made if one does not only select the correct strategy but also the anticipated time it will take for an asset to reach its target price.
You can see the P&L profile for our Cotton futures options trade below.
If you look at the dotted ‘expiry’ line you will see that any drop in Cotton will yield a small profit. This is the collection of the initial net credit received as mentioned above. Overall should we be right in our call, a position set up for a credit of $270 could yield as much as $3000 at expiry, a truly impressive return with a very low overall risk.
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