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Trading Idea: Sell December Cotton 100 Call Option, Buy July 100 Call Option

05/22/2018 11:09 am EST

Focus: COMMODITIES

Carley Garner

Senior Strategist & Broker, DeCarley Trading, LLC

December cotton generally peaks out sometime in late-May or June and indicators suggest the market is overpriced, writes Carley Garner, senior strategist for DeCarleyTrading Tuesday.

We have been stalking the cotton market for a potential bearish premium collection trade for weeks.

We are finally seeing the setup we were hoping for: an RSI poking above 70, a large up-day, and explosive call option prices. Additionally, the seasonal tendency for the December cotton futures contract turns bearish in late-May or June, giving us a little extra confidence.

However, we acknowledge that cotton is a thinner market and is prone to messy tops and bottoms. Thus, we prefer having insurance in place.

We like the idea of selling the December cotton 100 call option and then buying the July 100 call option. The net credit should be around $500 per contract before transaction fees. This represents the maximum profit on the trade.

chart

The maximum loss is not quantifiable because the insurance (July 100 call) expires before the short option expires.  Yet, during the time the insurance is active, our guess is the loss shouldn't exceed $1,000 to $1,500ish (although we cannot be certain of this). 

On the flip side, the December 100 calls have nearly tripled in value since last week, so a reversal or pause in the rally should cause the options to lose value quickly.

The margin on this trade is about $500.

There is a substantial amount of risk involved in trading futures and options.

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