ICE May Cotton futures are setting up well as a low-risk, high-reward mean reversion trade. One of our preferred set-ups is countertrend trades in the direction of the longer-term trend. In the following image, May Cotton closed below its two-hundred-day Simple Moving Average (SMA) while simultaneously signaling a temporarily overbought condition as defined by the nine-day RSI registering a reading above seventy. This means that the market is temporarily overbought within the context of a longer-term bear market. Of course, RSI readings above seventy mean nothing in and of themselves; we need evidence of a reversal in the form of lower prices, which is exactly what occurred on March 30, 2012. Moreover, this weakness occurred despite strength in other agricultural commodities (CME Group May Corn futures actually settled lock limit up on the day).
Although there are many ways to trade this set-up, we prefer the lowest risk alternative of selling the Friday 93.52 (or higher) settlement price and placing a protective buy stop just above prior cycle highs ‒ in this case, Thursday's high of 94.39 (please note that an open above Thursday's highs would have invalidated our sell signal). Our target for at least twenty-five percent of the position is just below Friday's low of 92.28. If this target is reached, we will lower our buy stop on the remainder of the position to just below our short entry price so as to prevent a significant unrealized profit from turning into a significant realized loss. Our profit target for the remainder of the position could be the twenty-day Simple Moving Average, or could be set to recent cycle lows ‒ in this case, 87.00.