Big Futures Traders Are Shorting the Cotton Market. Is a Major Move Coming?

Earlier this month, the cotton (CTK25) futures market hit a three-plus-year low basis nearby futures (KGH25), and prices have been trending down for the past year. This week has seen a decent corrective bounce in cotton futures prices, mostly due to the speculative sellers taking profits from their previously established short positions (also known as short covering).

How Different Segments of Cotton Traders Are Playing the Futures Market

The latest Commitment of Traders (COT) report from the Commodity Futures Trading Commission (CFTC) shows that large-sized futures traders, also called “the funds” or managed money, continue to sell short the cotton futures market. For the week ending Feb. 4, managed-money traders had added 7,829 contracts to the short side, for a total of 96,455 short, or sold, contracts. This compares to the managed-money traders holding long positions of 34,048 contracts in the latest weekly report. 

The COT report is released weekly on Friday afternoon. The COT reports provide a breakdown of each Tuesday’s open interest for major futures markets in which traders or hedgers hold positions equal to, or above, reporting levels established by the CFTC.

A money manager is a registered commodity trading advisor (CTA) or commodity pool operator (CPO) or an unregistered fund identified by the CFTC. These traders are engaged in managing and conducting organized futures trading on behalf of clients. This category can also be called the large speculator category. 

What is most important for the individual trader (you) to examine in the reports is the actual positions of the categories of traders – specifically the net position changes from the prior report. 

The Smartest Guys in the Room

Arguably the most important aspect of the COT report for most traders is the change in net positions of the swap dealers and producers category. This category in the older COT reports used to be called the “commercials.” 

Studies have shown that end-users and producers hold a superior record compared to other trading groups in forecasting significant market moves. The large producers and end-users are generally believed to have the best fundamental supply and demand information on their markets and thus position their futures trades, or hedges, accordingly. Along with the advantage of having the best fundamental supply and demand information on their markets, large producers and end-users also trade large size, which by itself moves markets in their favor.

The latest COT data showed that swap dealers and producers are long 53,058 cotton futures contracts, while the same group is short 10,463 contracts. That suggests that the smart money thinks there is more price upside potential for cotton, at present levels, than price downside potential.

Veteran cotton analyst Alan Barrett of the Higby Barrett research report says, “I believe the commercials are still the smartest guys in the room, but they speculate much more than in the past. They also use options to hedge the risk.” Barrett said the on-call program usage increases the commercials’ long positions. A cotton on-call position is a legal contract in the cotton market whereby a buyer or seller agrees to purchase or sell a specific amount of physical cotton at a later date. The final price is determined based on the price of a specified futures contract delivery month.

How to Best Read the COT Reports

It's important here to note that whether a particular trader group is net long or net short is not important when analyzing the COT report. For example, producers in silver have never been net long because they hedge their sales. In gold, however, the producer and end-user group is more heavily weighted toward fabricators who buy long contracts as a hedge against future inventory needs. So, again you need to look at the net change in positions from the previous report or several of the recent reports.

For individual traders, positioning on the same side of the market as large producers and end-users, when they become one-sided in their market view, is still arguably the best way to utilize the COT report.

Some traders like to take the opposite side of the trades in which the small traders (other reportable positions) in the COT reports are shown taking. This is because most small speculative traders of futures markets are usually under-capitalized and/or on the wrong side of the market.

The Heavily Bearish Cotton Boat May Now Be Tipsy

Some traders will follow the coattails of the large speculators, thinking the large specs (managed money) must be good traders or they would not be in the large-trader category. However, veteran traders also know that markets often tend to overdo it on the upside and on the downside. With the swap dealers and producers (smart money) on the long side of cotton futures and managed money heavily loaded up on the short side at present, a strong argument can be made that such is a signal that a major price bottom in the cotton futures market is very close at hand.