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Blow-offs phase in cotton market
Oct '10
NY futures exploded to the upside this week, with December rallying 1427 points to close at 118.87 cents (synthetic), while March advanced 1339 points to close at 114.75 cents (synthetic).

It has been a historic week, because December's synthetic close of 118.87 cents marks the highest futures price ever, eclipsing the April 29, 1995 high of 117.20 cents, and the market doesn't look like it's done breaking records just yet. We have now entered what appears to be the blow-off phase of this rally, with prices ascending in parabolic fashion.

As shorts are being forced to run for the hills, what typically follows at this point is a "climax top", when prices accelerate out of a base and get overextended. It is not unusual to see the market rise 25-50% in just a couple of weeks in such a situation. The short-covering is often so strong at this stage that it will create "exhaustion gaps" on the chart, where the lows of the day are higher than the previous day's highs. This typically occurs after the market has already made a significant move to the upside.

The fuel during this phase is short-covering. According to the latest CFTC report, the trade was still 12.6 million bales net short as of October 5. Although that's nearly 3 million bales less than the 15.5 million bales net short on September 14, it is the gross short position that deserves attention since it has remained stubbornly high.

As of last week, there were still 23.26 million bales in outright trade shorts, just slightly less than the 23.75 million bales on September 14. In other words, the reduction in the trade's net short position was not the result of short-covering, but was mainly due to an increase in outright trade longs, which presumably were established by mills trying to protect unfixed on-call commitments.

It becomes quite obvious why the market is melting up when we quantify how much margin money has been sent to New York over the last three months. Based on an average trade net short position of 12.5 million bales, the 40-cents move translates into 2.5 billion dollars, and if we measure it based on the average gross short position of roughly 20.0 million bales, we are talking about 4 billion dollars. It would be a stretch to envision that the trade has that kind of margin money readily available, especially since there is hardly any collateral at the moment.

What we are witnessing in the futures market right now has a lot more to do with a shortage of money than a shortage of cotton. The way the action unfolded on the board this morning seems to confirm that, because it was December that led the charge, while March, May and July appreciated much more slowly.

Spreads were very active today, as Dec shorts tried to escape the front squeeze by rolling their shorts into later months. Only once Dec was locked the limit did we see the back end catch up. If the market was concerned about the statistical shortage, there would be much more buying interest in the back months, since the perceived statistical tightness won't materialize until the second and third quarter next year.

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