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  • Price quality

    Chapter 4 - Cotton trading - Cotton futures and options – ICE Futures U.S. 

    Liquidity is critical in determining the success of a futures market. A futures market that has enough participants with competing price goals (buyers and sellers) can produce a turnover high enough to permit buying and selling of contracts at a moment’s notice without direct price distortion. Large transaction volumes provide trading flexibility (liquidity) and enable traders to pick the most appropriate contract month, corresponding to their physical delivery commitments, and to hedge the price risks inherent in that physical transaction. More bids to buy and offers to sell in the market at any given time increase pricing efficiency for the participants. A mature marketplace such as the ICE cotton market provides the necessary deep liquidity on a global scale.

    Speculators and hedgers competing for price helps the futures and cash prices to move in the same direction over time, and creates price convergence near the contract expiration. The futures market, however, may not always completely reflect cash market conditions, especially over a very short term period when large volumes may be traded for purely speculative reasons. The volume of futures trading (and the underlying physical quantity of cotton represented) may easily exceed total production of cotton. The fundamental conditions of supply and demand in the marketplace and the execution of related hedging strategies by segments of the cotton industry generally correct any short-term variations that may come from increased speculative activity.

    It is important for cotton hedgers to be aware of the activity of investors (speculators) in the market. For that reason, the futures industry regularly examines and publishes the ratio of speculative and hedging activity in the market. Speculators are absolutely necessary to the efficient function of a futures market. Speculative activity directly improves liquidity and serves hedgers’ long-term interests.

    Periods of extreme price volatility can also affect price efficiency. If everyone is primarily trying to sell, or if most traders want to buy at any given moment in the market, the price moves quickly and it may be more difficult to achieve price goals. The presence of speculators with short-term goals and strategies (often less than a day) becomes even more important during the periods of increased volatility, because they may enter and exit the market quickly on either the buy or sell side and provide more pricing points during the trading day.

    Options on futures provide speculators with yet another opportunity as well as offering risk managers greater flexibility in planning and executing hedging strategies. In recent years options have become more and more important to the cotton industry and on some business days actually exceed futures in trading volume.