July Cotton's Diamond

04/11/03 10:47:51 AM

by David Penn

Is the two-month diamond consolidation at the top of the cotton rally a signal that a top is near?

Security: CTN02, CTN2
Position: N/A

I don't know if the fish are jumpin', but cotton is certainly moving higher. Cotton had been putting in a bottom ever since making a major low in November 2001 and successfully testing that major low in May 2002 (see my article "It's Bottoms Up in the Cotton Club," June 7, 2002, Traders.com Advantage for more about long and intermediate term trends in cotton futures.)

The picture of cotton looks significantly different from the point of view of nearby contracts compared to the view of continuous futures. For example, the July contract that is the focus here clearly shows a higher low in the spring of 2002 (instead of the "matching low" shown on charts of continuous futures). Even more importantly, the July contract shows that the cyclical bear market in cotton futures that developed over the summer of 2002 did not take prices below the "breakout" level established by the rally high midway between the November 2001 and April 2002 troughs.

Note the rising money flow at the beginning and end of the diamond consolidation, just as prices appear to be breaking out.

Graphic provided by: TradeStation.

Thus, cotton's bull market has extended from November 2001--with July cotton priced at about 39--until the present--with July cotton trading near 60. By now, while further advances are possible, it is clear that cotton's bull market is in its mature stage--especially with it having broken out of cyclical bear markets in May 2002 and again in October 2002. This is almost a 54% gain, and even though 60 cents is not a breathtakingly high price for cotton based on historical levels (it is actually a pretty moderate price), it is reasonable to suggest that cotton's run is closer to its end that to its beginning.

What sort of end? Most immediately, there appears to be a diamond consolidation developing in cotton futures, a diamond consolidation that begins in the February 2003 advances. I am being careful to call it a consolidation because diamond formations can function as both continuation patterns (i.e., more price action in the direction of the prevailing/previous trend), as well as reversal patterns. The current diamond consolidation is a little over 4 cents in size from top to bottom. Diamond breakouts are measured not by adding or subtracting the formation size to the top or bottom of the formation--as with many other chart patterns--but by adding or subtracting the formation size from the point at which prices breakout from the pattern. As such, with prices in July cotton appearing to break out at 59, an upside of approximately 63-64 (or, conversely, a downside of 55-54) should be expected.

Part of my reservation about calling a top in cotton comes from a Fibonacci projection of a likely Elliott wave count of the cotton bull market from the October 2001 lows. I won't go too deeply into the wave count I've plotted for myself. Suffice it to say that wave one ends at 49.49 in February 2002, wave two ends with the lows of April, wave three peaks at about 55 in June, and wave four troughs in October. I use Robert Fischer's methodology for projecting the end of wave five (Fischer's "Fibonacci Applications and Strategies for Traders" is something every Elliott wave or Fibonacci-friendly trader should strongly consider adding to his or her trading library. In the meanwhile, for a quick review of Fischer's method, see my Traders.com Advantage piece, "Fibonacci and Fifth Waves" from February 11, 2003). This methodology--based on my wave count--suggests that a fifth wave in July cotton could likely end between 65 and 67 cents. The fact that this projection is close to the upside projection from July cotton's developing diamond consolidation only underscores the shifting of risk against the longs once cotton reaches these levels.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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