Commodities are markets that many individual traders have ignored in the past. They have been traded with futures contracts in a market that is in some ways riskier than stock markets. Futures can have unlimited financial risk while stocks and ETFs can be bought with the amount of risk limited to the amount paid for the purchase. While a 100% loss is rare in stocks, because futures are leveraged, that kind of loss can happen with an alarming frequency in the commodity markets.
Market changes in the past few years have made commodities available to individuals with the same degree of financial risk as a stock. Exchange-traded notes (ETNs) are very similar to ETFs. The difference is that ETNs hold derivative contracts, like futures contracts on commodities, rather than stocks like ETFs do.
Just like ETFs, some ETNs are too risky for most investors but others are very tradable. In order to be tradable, the ETN should be issued by one of the largest sponsors, the trading price should be very close to the underlying net asset value, and the ETN should have at least $10 million in assets. This information can be found on the sponsor’s website, and iPath DJ-UBS Cotton Subindex Total Return SM Index (NYSEARCA:BAL) meets all of these requirements.
Cotton seems to be at the beginning of a bull market right now, and that makes BAL a buy. Before looking at how to trade BAL, we’d like to look at the cotton market. Price forecasts based on the fundamentals of any futures market require a great deal of specialized knowledge, but technical analysis can provide enough insight into the market and give traders all the information they need.
Large traders in the futures markets are required to report their holdings to regulators and this data can be found in the Commitment of Traders (COT) report. The data is updated by the Commodity Futures Trading Commission every week.
Market participants are classified as commercials or speculators. Commercials are farmers and industrial users of cotton, like clothing manufacturers. They use futures in an effort to control their profits and they can have either a long or short position.
In the chart below, we can see that the commercial participants are holding more cotton than they have at any time in the past six years, an indication that they expect prices to rise. (If commercials expect prices to fall, they will be short since they believe they will be able to buy later at a lower price.) They have been long at the end of only seven months in the past five years. The last time commercials were long in 2009 would have been an ideal entry point for traders.
The chart also shows the relative positions of commercials and large speculators, a group that includes hedge funds. That data has been converted into an index with high values showing the degree of bullishness. Right now, commercials are strong bulls and speculators are betting against them. Commercials tend to know the market better than speculators and are usually right when they take a large position.
The next chart adds to the bullish case for cotton:
Commodities tend to move in long cycles. The chart shows the 20-year cycle, which has been useful for predicting turning points in cotton in the past. That cycle bottoms in October 2012, and shows the potential for a long-term bull market in cotton. Stochastics is bullish on both the monthly and weekly charts, offering a more traditional buy signal for the market.
Stock market traders can use BAL to participate in this bull market. BAL has just broken above the upper Bollinger Band on both the weekly chart (shown below) and the daily chart (not shown).
In the past, BAL has moved up 83% of the time over the next two months after breaking the upper Band. The average trade has gained 11.7% over that time, and a repeat of that performance would push BAL into resistance near $57.
While this trade has a high probability of success based on back-testing, the relative reward may be considered small to some traders. Call options offer a way to increase the potential reward. December options with a strike price of $55 are trading at about $0.75. If BAL reaches the price target of $57, these options would be worth at least $2 and the potential profit would be 167%.
Action to Take –> Buy BAL at the market price. Set stop-loss at $46.86, the low of the breakout bar. Set initial price target at $57 for a potential 11% gain in two months.
Buy BAL Dec 55 Calls for $1 or less. Do not use a stop-loss. Set initial price target at $2 for a potential 100-plus gain in two months.
This article was originally written by Michael Carr, and posted on StreetAuthority.