January 30, 2007
The PERFECT "2 and 1"
With Cotton option prices being as deflated as they are, the trade outlined below would have "worked" every year for the past 25 years. By "worked", I mean in every single year since 1982 you could have either recouped your entire investment when cotton's biggest move was down, or, in those years when cotton's biggest move was up, had the opportunity to bank AT LEAST a 75% return at some point before the July contract expires, 159 days from now.
This is all math. In a sense, my bullish opinion has nothing to do with this recommendation....Just follow the numbers that follow...
First, just take a look at how much July Cotton has moved between now and its expiration on July 9th during the past 25 years. The table below lists the biggest move away from the January 31st close, whether it was up or down. There have been some very large moves, but what is of the most importance here, however, is to note what the smallest moves have been.
25 Year History, Every July Cotton Contract, From January 31st Close To Expiration:
The Largest Trade (In Either
Direction), In Cents
There have been 13 years when the greatest move was up and 12 when the greatest move was down.
Do note the SMALLEST moves were: Down 6.70 and Up 7.05...With this in mind, I think it is safe to say, before July Cotton expires, it should move AT LEAST 7 cents away from where it is now.
So here is the recommendation, the math and the money...
July Cotton closed at 55.48 today. The July 57 call closed at 1.87 cents and the July 55 puts closed at 2.26 cents.
Basic unit: Buy 2 July 57 calls @ 1.87 and 1 July 55 put @ 2.26. Total cost is 6 cents. With commissions, you will spend $3180, or the equivalent of 6.36 cents.
Here's the way it looks and how it works out if the market goes down or up...
Here's the same chart with a slightly different perspective...To me, even without the 25 year history, moving up or down 7 cents by the time July fills in the rest of this chart just doesn't look like any big deal....
It is almost irrelevant that I think this is the year when Cotton truly takes off, or that is quite possible we could/should minimally see a 15 -20 cent rally in this contract. What is relevant is the 25 years of history indicating you can put your money on the table, be wrong, and have an extremely high possibility of either getting it all back (with Cotton then in the 40's and you do it again), or, of knocking out, at a minimum, close to a double. Obviously, I have to say it is possible Cotton could just lay here between 55-57 cents for the next five months and both the calls and puts could end up worthless.
For those of you who remember it, this is very much like the old New Year's gold trade, only better (I believe) in that it has over 5 months to work for us...
I also need to add that the Intercontinental Exchange (ICE) will be adding Cotton to its electronically traded contracts next week...I don't see how this can mean anything but a dramatic increase in trade volume, either immediately or over time, and with it, I would expect volatility in cotton to do the same as well...which should only help the prospects for this trade.
Finally, I have to say these stats actually make a highly logical argument for turning this into nothing but a volatility trade...That is, you establish both a long and a short position (using the 2 and 1 for each side) totally independent of each other. As, or if, cotton makes that 7 cent move, one side should get its money back, while the other generates that 75% return. This takes twice as much money per unit, but if you throw out opinion, and just view this mathematically, the logic is undeniable.
Give me a call if you're interested...