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Another historic week for cotton market
Dec '10
NY futures were on a rollercoaster ride, but in the end March closed the week just 200 points higher at 148.12 cents, while new crop December dropped 95 points to close at 95.80 cents.

It was yet another historic week, with March setting a new all-time high at 159.12 cents on December 22, although intra-day prices based on spreads were trading as high as 166 cents. The spot month finished every session of the week with a limit move - three limit-ups followed by two limit-downs.

Technical traders seemed to get more excited by what happened after the March contract jumped to a new historic high. Because the market left gaps on the chart that isolated the record-setting session of December 22, it formed what's called an "island top reversal", which is regarded as a rare and powerful reversal pattern. It often serves as a good indicator of a primary trend change that provides a 'tradable top'. Reinforcing this island reversal is the fact that it coincides with what looks like the beginning of a double top on the longer-term chart.

So we currently have bearish technical forces clashing with a bullish fundamental scenario and session serves as a great example of this struggle. After overnight selling had forced the March contract limit down, a surprisingly strong US export sales report (over 400'000 bales of Upland and Pima combined) emboldened buyers in the morning and as a result the spot month rallied by over 700 points in a little over an hour, only to see renewed spec selling knock it back down again.

After several sessions of restricted trading due to limit moves, some of which forced options trading to be halted, trading was mostly free flowing, which allowed nearly 25'000 futures and around 18'000 options to change hands. The increasing volume coupled with the limit down move is feeding into the short-term bearish scenario.

While we generally respect what the chart is telling us, we have some reservations in regards to this island top. By definition an island top occurs when the market exhausts itself to the upside after buyers were chasing it higher on some bullish news and/or shorts were forced to cover. Volume typically accelerates on both the initial breakout and the subsequent failure. Also, island reversals are mostly news driven and happen because of conflicting fundamental stories.

However, there are several things missing here. For one, trading was relatively thin and even though there was some short covering, open interest has hardly dropped over the past few weeks. In fact, when we look at the latest on-call report, we notice a net increase in unfixed on-call sales for a second week in a row. As of last Friday there were still 10.24 million bales to be fixed, up 224'800 bales net from last week. In other words, while some shorts may have covered during the recent run up, the majority of them are still in the market.

Also, the fundamental story hasn't changed, if anything the 400'000 bales of US cotton that were sold last week have reinforced the bullish case. According to our calculation there are less than a million bales for sale in the US and we still have over 9 months to go until new crop arrives. Retail demand is going strong, not only in emerging markets like China and India, but even in the US and Europe, where Christmas sales are apparently surpassing forecasts. There are several stories about retailers running out of inventory because they were too cautious in their expectations.

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