Cotton Futures Trading Basics

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Cotton Futures Trading Basics

Cotton futures are standardized, exchange-traded contracts in which the contract buyer agrees to take delivery, from the seller, a specific quantity of cotton (eg. 50000 pounds) at a predetermined price on a future delivery date.

Cotton Futures Exchanges

You can trade Cotton futures at New York Mercantile Exchange (NYMEX).

NYMEX Cotton futures prices are quoted in dollars and cents per pound and are traded in lot sizes of 50000 pounds .

Exchange & Product Name Symbol Contract Size Initial Margin
NYMEX Cotton Futures
(Price Quotes)
TT 50000 pounds
(Full Contract Spec)
USD 3,375 (approx. 15%)
(Latest Margin Info)

Cotton Futures Trading Basics

Consumers and producers of cotton can manage cotton price risk by purchasing and selling cotton futures. Cotton producers can employ a short hedge to lock in a selling price for the cotton they produce while businesses that require cotton can utilize a long hedge to secure a purchase price for the commodity they need.

Cotton futures are also traded by speculators who assume the price risk that hedgers try to avoid in return for a chance to profit from favorable cotton price movement. Speculators buy cotton futures when they believe that cotton prices will go up. Conversely, they will sell cotton futures when they think that cotton prices will fall.

Learn More About Cotton Futures & Options Trading

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Cotton: An Age-Old Commodity Worth Billions. Read This To Decide If It’s Right For You

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Last Updated on September 13, 2020

Why is Cotton Valuable?

Cotton is a fluffy natural fiber that grows on shrubs in tropical and subtropical regions around the world. The commodity is a staple in the textiles industry.

Historians don’t know the precise origins of cotton, but cloth found in caves in Mexico proves that the crop was around more than 7,000 years ago. Since the Age of Antiquity, civilizations around the world have spun cotton fibers into cloth garments.

However, two events in history – the Industrial Revolution in England and the invention of the cotton gin in the United States – profoundly changed the role cotton plays in world markets. These events led to widespread production of cotton garments and turned cotton into a multi-billion dollar global industry.

How is Cotton Grown?

Cotton plants grow in warm regions of the world where there is ample sunshine and limited frost.

Cotton farmers plant their crop in the spring and harvest it in autumn. Prior to planting, farmers prepare the land using either the no-till method, where they use special equipment to deposit the seeds on the soil’s surface, or the till method, where they plow the land into rows forming seedbeds for planting.

About two months after tilling, tiny flower buds appear on the green, bushy shrubs that grow from the ground. In another three weeks, the flowers begin to blossom.

The flower petals will begin to change color – from white to yellow to pink and finally red – and then fall off the shrubs. What remains are tiny green pods called cotton bolls. These bolls ripen further and develop small fibers inside of them. As these fibers expand from sunshine, they burst out of the pod in the form of fluffy cotton.

Machines then harvest the fully ripened cotton into conveying systems that process the crop for consumption.

Over 80 countries cultivate one or more of the four species of the crop, but the main production crop is the Upland cotton variety:

Species Common Name Native Region % of Global Output
Gossypium arboreum Tree cotton India and Pakistan Less than 2%
Gossypium barbadense Extra-long staple cotton South America 8%
Gossypium herbaceum Levant cotton Southern Africa and Arabian Peninsula Less than 2%
Gossypium hirsutum Upland cotton Central America, Mexico, the Caribbean and Florida 90%

The largest cotton producing county is China. It has 100,000 cotton farmers, 7,500 textile companies and $73 billion in annual cotton cloth production.

Top 10 Cotton Producing Countries

Rank Flag Country Cotton Produced (1000 480 lb. Bales)
#1 India 30,000
#2 China 25,000
#3 United States of America 21,377
#4 Pakistan 9,150
#5 Brazil 7,800
#6 Australia 4,800
#7 Turkey 3,800
#8 Uzbekistan 3,700
#9 Mexico 1,500
#10 Burkina Faso 1,420

China is also the largest importer of cotton. The country imports over $7.5 billion of cotton annually (about 17% of global production). Other large importers of the commodity are Bangladesh, Vietnam, Turkey and Indonesia.

Cotton is known as a versatile fiber that is comfortable to wear. However, its applications extend beyond its use in clothing.

4 Main Uses of Cotton

Use of Cotton Description
Cotton Fiber

Woven or knitted into a variety of fabrics used to make clothing and household items. These fabrics include:

  • Corduroy
  • Chambray
  • Velour
  • Jersey
  • Flannel
    Used in other miscellaneous products including:
  • Fishnets
  • Coffee filters
  • Book binding
  • Archival papers Cottonseed

    Used as a feed for livestock. Cottonseed Oil

    Used as a cooking oil. Cottonseed oil is also found in many consumer products including:

  • Soap
  • Margarine
  • Emulsifiers
  • Cosmetics
  • Pharmaceuticals
  • Rubber
  • Plastics Linters

    These are small fibers that remain on cottonseed after processing. Linters are used to make:

  • Bandages
  • Swabs
  • Bank notes
  • X-rays

    What Drives the Price of Cotton?

    The price of cotton is driven mostly by these seven factors:

    1. Global Stockpiles
    2. Government Policies
    3. Global Demand
    4. Climate
    5. Price of Substitutes
    6. Oil Prices
    7. The US dollar

    Global Stockpiles

    In the recent past, China has engaged in enormous stockpiling to ensure they have an adequate supply of cotton.

    These actions have often resulted in higher domestic prices for cotton in China than in the rest of the world. If China were to sell off all of its stockpiles because of weak domestic demand, then prices for cotton would likely go lower.

    On the other hand, if Chinese hoarding creates global shortages, prices could go higher.

    Government Policies

    Numerous governments including the United States heavily subsidize cotton farmers. Subsidies have the effect of keeping the supply of cotton artificially high and its prices artificially low.

    Brazil has pursued and won cases against the United States through the World Trade Organization to stymie these subsidies. However, a recent US farm bill increased subsidies for cotton. The prevalence of subsidies can have a meaningful effect on cotton prices.

    Global Demand

    The global demand for cotton is mostly a function of the overall health of the economy. Cotton is largely a discretionary item, and consumers can choose other cheaper synthetic fabrics, such as polyester, if the economy is weak. China plays such a key role in the cotton market that its economy in particular bears watching.

    Climate

    As with all agricultural commodities, climate plays an important role in driving cotton prices. Cotton needs warm weather, adequate rainfall and little or no frost to grow properly. Poor weather conditions in key growing regions in India or China, for example, could create supply shortages and prices spikes. On the other hand, ideal weather conditions could create bumper crops.

    Good Weather Can Provide Bumper Crops – Image via Pixabay

    Price of Substitutes

    The production and price of substitute fabrics such as polyester can play a key role in determining cotton prices. China is a major producer of purified terephthalic acid (PTA), which is the raw material used to make polyester. Historically, production decisions related to PTA can dramatically impact its demand. These decisions, in turn, can affect cotton demand and prices.

    Cotton traders should pay close attention to the market dynamics of PTA.

    Oil Prices

    Cotton is an expensive crop to produce. The machinery and motor vehicles needed to operate farms represent a significant component of overall costs. Machines and equipment require fuel, so crude prices can greatly impact cotton production.

    In addition, PTA is produced from oil, so a rise in crude prices could make polyester more expensive and raise demand for cotton.

    The Specialist Machines Needed Contribute Greatly to the Overall Costs of Cotton Production – Image via Pixabay

    The US Dollar

    Most commodities, including cotton, are priced in US dollars. When the value of the dollar drops against other currencies, it takes more dollars to purchase cotton than it does when the price is high. Buyers purchasing cotton in other currencies see their purchasing power increase when the dollar is weak and decline when the dollar is strong.

    Cotton Futures Trading Basics

    * Paper adapted and presented by a staff member of the International Institute for Cotton, Liverpool. Original version written by Dr. Gordon Gemmill, City University of London, Business School.

    1.1 A FUTURE is a legally binding contract to deliver/take delivery on a specified date of a given quality and quantity of a commodity at an agreed price.

    1.2 Futures trading began during the American Civil War. Prices for grain and cotton were very unstable. In 1865 the Chicago Board of Trade began collecting INITIAL MARGIN and VARIATION MARGIN to make sure that speculators fulfilled their obligations.

    The initial margin is enough money, paid in advance, to cover one day’s potential loss.
    The variation margin is one day’s actual loss (or gain), paid in arrears.

    1.3 By 1867 there was a large market in Liverpool in “cargoes to arrive” and in 1869 the Cotton Brokers’ Association had published rules for “contracts in cargoes to arrive”. In 1876 a system of CLEARING was devised and the organization to do this was at first the Cotton Brokers’ Bank (1878) and merged into the Liverpool Cotton Association in 1882.

    1.4 What distinguishes a futures contract from a forward contract?

    (i) CREDIT – in a forward contract the two parties have to trust each other, whereas the collection of margins on a futures contract removes all credit.

    (ii) STANDARDIZATION – forward contracts have terms to suit the two parties, whereas futures contracts specify a standard quality, delivery month, location, system of payment, etc.

    (iii) PUBLIC PRICES – forward prices are not always known, whereas futures prices are published.

    (iv) PURPOSE OF TRADE – most futures contracts are not delivered, but re-sold (or re-purchased) prior to delivery because their purpose is to cover price-changes rather than to obtain the goods.

    1.5 Where are the futures markets?

    Chicago – grains, soyabeans, cattle, pigs
    New York – sugar, cocoa, coffee, COTTON, oil
    London – sugar, cocoa, coffee, oil
    Paris
    Sydney
    Kuala Lumpur
    Hong Kong

    1.6 What do futures prices “Look Like”?

    New York Cotton Exchange, dosing prices, 5.6.85
    (50,000 lb contract, prices in cents per lb)

    March

    Arbitrages are riskless trades which bring prices to their “correct” levels.

    5.1 Time arbitrage

    March 20

    buy spot cotton at $0.5990 and sell July futures at $0.6290

    July 31

    deliver cotton

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    gain = $0.03/lb i.e. 5.00 %, – less storage costs

    You would do this if storage costs were less than 5 % over the 4 months.

    5.2 Space arbitrage

    Not possible in cotton. In other products, buy futures in London, sell futures in New York and hope to make a profit on difference in prices.

    The term “basis” is used to describe the difference between the price of the commodity in the actual market and the price of the futures contract in the same commodity.

    BASIS = CASH PRICE minus FUTURES PRICE.

    The basis can be either positive or negative.

    The concept of basis strengthening can be summarized as the basis becomes more positive.

    The concept of basis weakening can be summarized as the basis becomes more negative.

    The basis is comprised of two components:

    * The time-associated component.
    * The distance-associated component.

    The time-associated component of the basis may be described as the costs of carrying the physical commodity for a future date. Costs of carry consist of the costs of storage, insurance, interest, etc.

    The distance-associated component of the basis may be described as the costs of transporting the physical commodity to a different location. Transportation costs reflect the fact that the commodity may be produced in a location different from that where it is delivered.

    Changing supply and demand factors in different local markets, availability of transportation facilities and unexpected factors such as labour disputes may result in a difference between the cash price and the futures price.

    Changes in the cash price and the futures price of a commodity: have a tendency to move in concert with each other.

    Fluctuations in the basis tend to be less volatile than fluctuations in cash and futures prices. The basis is generally more predictable than both cash prices and futures prices.

    2. Organization of futures markets

    1. Trade occurs around “rings” or “pies” and traders shout bids and offers to each other across the middle.

    2. The Clearing House is responsible for collecting the initial margin from each buyer and seller and collects/pays out variation margin every day. The Clearing House is also responsible for organizing delivery of the goods and payment.

    3. Each member of a market acts as a clearing house to his own customers, calling them for margin as required.

    3. Why some commodities have futures and others none

    1. Is the cash market large enough?
    2. Is the price sufficiently volatile?
    3. Are there enough independent buyers and sellers?
    4. Can the commodity be standardized?
    5. Are existing forward contracts flexible enough anyway?

    4. Speculation (trading) with futures

    4.1 Simple trade

    View – expect July price to fall

    March 1

    sell 10 lots July at 60.00 cents/lb

    (each lot is 50,000 lb)

    (initial margin = $ 1.500/lot, so $ 15,000 total)

    (value of cotton controlled = $ 30.000 x 10 = $ 300,000)

    March 20

    buy 10 lots July at $ 0.59/lb

    gain = $ 0.01/lb on 10 lots

    = $ 0.01 x 10 x 50,000

    4.2 Spread between months View – expect October to rise relative to July

    March 1

    sell 1 lot July at $ 60.00

    buy 1 lot October at $ 58.40

    June 5

    buy 1 lot July at $ 62.94

    sell 1 lot October at $ 61.55

    = $ 60.00 – $ 62.94 + $ 61.55 – $ 58.40/lb

    = $ 0.21/lb

    4.3 Spreads between commodities

    Some traders do “exotic” spreads (which are really just two trades).

    e.g. “Yellow Toyota” = sell Japanese yen/buy corn.

    The role of the Clearing House

    Daily settlement and marking-to-the-market

    1. Facilitates the flow and transfer of funds.
    2. Acts as a counter party to the futures contract.
    3. Assures the financial integrity of the market.
    4. Administers daily evaluation and settlement of profits and losses.
    5. Provides a mechanism for delivery or cash settlement.

    The futures exchange determines the daily settlement price for each contract traded.

    The clearing house uses the daily settlement price to credit the accounts of clearing members showing a net gain on their positions as a result of favourable price movements, and debit the accounts of clearing members showing a net loss due to adverse price movements.

    The principle of daily cash settlement permits the trader to withdraw any profit resulting from his futures trading on a daily basis.

    MARKING TO THE MARKET COTTON (CTN) 50,000 LBS; CENTS PER LB.

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