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FLAGS AND PENNANTS


December Cotton's June Flag

07/03/03 09:18:48 AM
by David Penn

A two-week pullback in cotton futures anticipates higher prices in the near-term.

Security:   CTZ3
Position:   N/A

Back in April, I was writing about the July cotton futures contract and the possibility that the market might be making a top ("July Cotton's Diamond," Traders.com Advantage, April 11, 2003). Although I posited both bullish and bearish scenarios, I did note that in all circumstances, cotton traders needed to be wary of the likelihood that cotton's bull market was ending-- whether or not there was still room enough to a short-term trade to the upside.

Interestingly, cotton broke out from its diamond formation in April and moved up to test resistance at the March highs. The March highs held and, in late April into May, cotton futures plummeted from 61 cents to just above 50 cents. Cotton futures rallied fairly sharply in the first few weeks of May only to collapse again, marking an even lower low around 48 cents.

Cotton bulls have been frequently frustrated by a market that has seemed incapable of sustaining a rally. After an extended decline beginning in 1995, cotton futures consolidated from 1999 to 2001. No doubt traders during this period saw in this extended consolidation the opportunity for the cotton market to make a real bottom. These thoughts were dashed by mid-2000 when cotton futures again began moving down-- and this time with even more rapidity than the decline from 1995 to 1999.

Note the declining volume trend during the development of the bullish flag in June.
Graphic provided by: TradeStation.
 
More recently, since the third quarter of 2001, cotton bulls have been repeatedly thwarted with aborted rallies in October 2001, March 2002, and October 2002. Thus it would make a great deal of sense for cotton traders to look at the most recent bullishness in cotton with suspicion.

But the technical case for a continued (read: tradable) rally in cotton futures is compelling. Cotton futures (basis December) have rallied strongly and sharply from their late May lows when the futures were particularly oversold. After moving up into previous resistance territory (actually, near the top of the diamond pattern referred to in "July Cotton's Diamond"), cotton futures retreated sharply in the form of a countertrend flag formation. A flag is a short-term (less than three weeks) countertrend consolidation that is bounded by parallel trendlines.


One important aspect of the flag in December cotton is that the formation began with a gap up in early June and the countertrend movement of the flag has not closed the gap. This suggests, so far, that the gap may continue to act as support for any near-term move to the upside.

The measurement rule for flags, as suggested by Thomas Bulkowski in his classic book, Encyclopedia of Chart Patterns is a bit less counterintuitive than the measurement rule for other formations. Using the chart of December cotton as an example, the measurement rule would call for taking the distance between the start of the current trend (the early June low of about 52.5) to the top of the flag formation (the early June high of about 60.9). This value (here, 8.4) is added to the value at the bottom of the flag formation (approximately 57.2). This calculation gives a projected minimum upside of 65.6.


What is interesting about this projection is that it would represent a contract high for December cotton. What is all the more interesting is that if December cotton reaches these levels, there is precious little resistance overhead. In fact, there are hardly any technical events between 64, the current high in the 2002-2003 consolidation, and about 85, the bottom of the diamond-shaped 1999-2001 consolidation (basis continuous futures). Perhaps the third trough will be the charm for cotton bulls in 2003 and beyond.



David Penn

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

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