Is the Worst Over for Cotton Shearing?

May.11.11 | About: iPath Dow (BAL)

We wrote about the big breakout in cotton commodities and the BAL ETF in February 2011, saying that while the uptrend was extremely strong, it was nearing a parabolic nature whereby a sharp correction could occur at any time. BAL then basically traded higher in a volatile range for the next couple of months, before a breakdown in April sheared over 37 points off the all-time high reached intraday on March 7.

Cotton was one of many commodities that has had a big runup over the past decade — long-term we’ve been bullish on many hard commodities (agriculture, metal, etc.) for some time due to relative/real value, potential inflation and growth in global demand. But when rallies get extremely overextended and parabolic in nature, the risk of a sharp pullback increases greatly.

The key during big uptrends is to recognize that a speculative mini-bubble may be occurring, and to keep this in mind while riding the trend higher. While it’s great to ride the trend higher (and we do quite often), don’t increase position sizes and also be sure to take profits quickly in the runup — and be prepared to bail out and possibly take short positions when the trend inevitably breaks down.

So where does cotton stand after this big pullback? I’ve placed a Fibonacci Retracement on the BAL chart below from when the uptrend began to accelerate in August 2010 to the high reached in March 2011. You can see that BAL gave up nearly 50% of its gains during this pullback.

The 50% retracement level is an important one in trends of all sorts, in addition to being a Fibonacci number. We quite often see a stock/index/ETF/commodity give up around half the gains in a trend before finding support and resuming the bigger trend. That looks likely in this case. The 50% retracement level of 76.59 should contain pullbacks at this point. And with BAL being a high-priced, volatile ETF, the round 80 level (round strike prices numbers are often psychologically and technically important as well) looks a good low-risk entry point for long positions on pullbacks.

[Click to enlarge]

BAL Daily Chart

Bottom line: The 50% retracement level of 76.59 should contain pullbacks at this point — basically the 75 area (round strike price numbers are often important levels from an open interest, psychological, and technical perspective) -- and should hold as support from here, in my analysis. And with BAL being a high-priced, volatile ETF, the round 80 level looks a good low-risk entry point for long positions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.