Cotton: Are The Sheep About To Get Shorn?

I haven’t seen much to talk about in the equity space, lately, so we're going to spend time looking at commodities -- specifically cotton. After the iPath Cotton ETF (BAL) topped in early 2011, it fell over 80% before bottoming in June of last year. Once all the sellers were shaken out, the commodity has seen a nice rally up to the $60 area.

Falling Trend
Lucky for Fruit of the Loom and Hanes, it appears cotton has hit a wall. BAL ran into the falling trend line created from the high of two years ago. Ideally we would prefer to see another previous test of the trend line to have more faith that it will hold as resistance, but we can use other methods of technical analysis to better understand if cotton can continue its advance or will correct.

Island Pattern
While it’s not very easy to see on the chart below, BAL has created an island pattern over the last three trading days. That means the cotton ETF gaped up and closed above the previous day’s high and then on the next day, it gaped and closed down below the previous day’s low. You can see why they call this an island pattern -- the gaps separate the bar/candle as if it were an island. This is a bearish pattern when it occurs in an uptrend. However since the island in BAL just involves a single bar rather than a cluster of trading days it is not a strong bearish pattern and is often viewed more short-term than other trading patterns.

Large Short Position
When we turn our attention to the COT data, the ‘smart money’ is currently holding a historically large short position in cotton. They are actually the most net-short they’ve been in the last three years. This gives a little more credence that cotton could experience further weakness going forward. What BAL bears will likely be looking for is to fill the gap below $75.50 and possibly test the short-term low of $52.50. On the upside we will see if the falling trend line holds or if bulls can bust through.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+.