Gold Futures CoT
Adam Hamilton April 15, 2005 3647 Words
With gold, silver, and gold stocks all in typical technical bottoming patterns, sentiment among precious-metals investors is understandably rotten. When prices feel low people feel bad. It is always this way near major interim bottoms.
While I receive countless e-mails laden with despair during times like these, one this week did a fantastic job of summing up how so many investors are feeling today. This gentleman, talking about gold stocks in particular, wrote to me…
“I am so tired of losing money on these stocks, it seems like we've been in a bear market for the last 2 years with occasional rallies that seem to get weaker. How can guys like you figure that these stocks are going to someday do well? When do I just give up? I’m at the end of my rope with everything related to Wall Street. It makes me sick and seems impossible to make money. I'm so frustrated I don't know what else to say.”
It is not difficult to detect emotional extremes in others, but it is hard to remain detached enough to see into our own hearts. One of the greatest struggles in any speculator’s journey is the constant war to overcome one’s own destructive emotions of greed and fear, euphoria and despair.
In my own evolution as a speculator, the most effective way I have found to keep myself on an even keel and strive for total emotional neutrality is to focus on the hard data. While our personal feelings about the markets are capricious and often misleading, the underlying data is absolute. It provides a solid intellectual reference point at which to anchor to weather out the storms of sentiment that periodically batter the markets.
Last week I discussed the irrationally pessimistic gold-stock sentiment that is seducing investors into selling low, at what is almost certainly just another typical major interim bottom. This week I would like to address another fear factor that I keep hearing about over and over again, the gold futures Commitments of Traders report. A growing number of investors are worried about the state of the gold futures CoT.
Like all bearish theses, bearish interpretations of the CoT gain much ground when prices are low and investors are therefore naturally predisposed to seeking out negative theories. I continue to get e-mails concerned about the commercials being short, worried about extreme bullishness in small futures players, and generally concerned that gold futures portend rough sailing ahead for gold.
The Commodity Futures Trading Commission releases its Commitments of Traders report once a week, each Friday. It summarizes changes in futures positions in all major commodities by all major players. While tremendously useful, the CoT is so complex that an air of mysticism has sprung up around it.
If you download the raw text file of 2004 futures data, for example, it is a whopping 4mb and contains 129 columns and nearly 3500 rows of solid data! Incidentally the single largest Excel spreadsheet I have ever created, while working on an analysis of S&P 500 CoT data a couple years ago, weighed in at 40mb. For comparison, a typical Zeal essay usually runs well under 1mb of raw data underneath the charts and maybe only 10 columns of data. Raw CoT data is voluminous, complex, and intimidating.
Since the raw CoT data is so specialized, not many investors or analysts bother getting into it. Those who do tend to be revered, kind of like high priests privy to some arcane knowledge. And just like with high priests’ decrees in religion, often the CoT data interpretations by gurus usually go unquestioned or uninvestigated by the faithful. In some cases this blind faith in others’ CoT interpretations can lead to problems.
While I have received lots of e-mails in the last couple months about the alleged dire state of the gold futures CoT reports, whenever I look at the data myself I fail to see any looming threats or even notable anomalies. Thus this week I would like to dig into the gold futures CoT from a strategic perspective, over the entire gold bull to date. Hopefully viewing the gold CoTs within their strategic secular context can help dispel the growing fear that their tactical interpretations seem to be causing.
We will start with gold futures open interest and then zoom into the breakdown of the various major players in the gold futures market. Charted out over the long term, the gold futures CoT slices through some of the week-to-week CoT mysticism and reveals a surprisingly bullish picture for gold.
The futures world is very different from the stock world with which most investors are familiar. Unlike stocks, futures are a zero-sum game. Every dollar you win in a trade is a direct loss for the counterparty on the other side of your trade, or vice versa. In addition, the total number of longs and shorts are always equal. Every trade has two sides so overall longs and shorts maintain equilibrium.
Open interest is the futures term used to quantify the total number of futures contracts outstanding. Since every single futures contract always has a long and short side, open interest equals the total number of longs (or, but not and, shorts) outstanding at the end of any given trading day. Over time, open-interest trends can reveal much about the state of the particular market traded, gold in this case.
The chart above overlays the gold price during the past five years or so over the gold futures open interest. This reveals a lot about the state of the gold market and the gold futures market, since open interest is ultimately a measure of the continuing willingness of traders to maintain opposing positions, to put their money where their mouths are.
Gold futures OI is rising over time along with gold. As any secular bull market marches on, more and more speculators get interested in playing the market. Nothing begets interest and excitement like higher prices! Just as there were far more tech-stock traders in 1996 than there were in 1991, there are far more traders interested in the gold market today than there were only a few years ago.
This is a healthy and typical bull-market sign in a futures market. A larger gold futures OI indicates ever more capital is betting on gold. And the more capital that bets on gold, the more volatile it grows as its uplegs and periodic corrections are amplified. This volatility attracts new traders to a market like dogs to a steak, as traders thrive on volatility which gives them more opportunities to profit. And the more capital interested in trading gold, the higher its price can ultimately run in this secular bull.
In contrast, in order for gold futures open interest to be bearish as so many investors fear today it would have to be falling. A falling OI would indicate traders liquidating positions and vacating the market, a sign of capital flight. And the less capital bidding on gold, the lower its volatility and potential interim highs. If speculators take their capital elsewhere, the gold bull would have a chance to wither and die. Obviously the chart above could not be any more opposite from this bearish scenario.
While OI has risen with the gold price, it is interesting that the OI has a steeper upslope than gold itself. I zeroed both axes on this chart to eliminate distortion so the visually steeper OI upslope is technically accurate. This is also another sign of a healthy and thriving futures market. As this gold bull marches on, traders are increasing their bets on gold at a faster rate than gold itself is climbing.
If these disparate growth rates continue, eventually the potential grows for an explosive move up in gold. With OI and hence capital bet on gold rising faster than the gold price, gold may have to surge at some point to catch up. I am really interested to see how this situation resolves itself, whether the OI upslope moderates or the gold upslope accelerates.
Another interesting, yet typical, observation is that gold futures OI generally peaks with interim tops in gold. This makes sense. Just as speculators grow too fearful and despairing during times like today when gold is carving bottoms, they wax too greedy and euphoric when gold is nearing major interim tops. The higher prices rise, the more traders want to bet on them and get in on the hot action.
For me the most fascinating, and unexpected, attribute of this chart is the fact that gold futures OI has carved its own fairly well-defined uptrend channel. Just as if it was price data, the OI has bounced consistently at the same linear support and collapsed roughly near the same linear resistance zone. When OI is at the top of this trend channel it tends to signal a major interim top in gold.
More relevant for today though, when gold futures OI is near its lower support line it tends to mark major interim bottoms in gold! Since this gold bull launched in early 2001, every single time that gold futures OI was near its lower support line gold rallied strongly in the subsequent months without fail. In fact, every major gold upleg was preceded by a support approach in gold futures OI.
Once again today gold futures OI is near its support, implying that a major rally in gold is again imminent. This strategic and undoubtedly bullish OI data flies in the face of CoT-based predictions for bearish gold action in the months ahead based on current futures data. Just as in virtually all market-related endeavors, the raw data analyzed in context effectively neutralizes any emotional waves buffeting the markets. Bearish sentiment or not, there is nothing remotely bearish about this chart.
Now that it is clear that gold futures demand is growing healthily just as it ought to, we can dive into even more arcane CoT realms that inspire even more fear than gold OI. A little background is in order to lay the foundation for understanding the following gold futures charts.
A common bearish gold theory gaining adherents today goes something like this. “The commercials are heavily short and they are actively capping gold. There is no way gold can rise in the face of all this shorting pressure. Therefore it makes little sense to be long gold or gold stocks right now.” If you have been interested in gold longer than a nanosecond, you have probably heard these CoT-based bearish gold theories.
As you consider the logic of this school of theories, it is crucial to remember one key indisputable fact of the futures world. In any futures market, longs and shorts are always equal. There are two sides to every trade and each long is perfectly matched with each short at all times. Therefore statements decrying big shorting in gold futures without elaboration are irrelevant and pointless in isolation. Big shorts necessitate big longs directly offsetting them!
Since longs and shorts are perpetually equal in gold, period, the gold futures CoT must be analyzed at a more granular level. The CFTC’s weekly report divides the futures traders into three groups known as commercials, non-commercials, and non-reportables. Understanding these three groups and their varying motivations is essential to properly interpreting CoT data.
Commercial traders meet the CFTC’s guidelines on hedging. In gold, commercial futures traders usually deal in the underlying metal itself in some way (mining, refining, etc) and therefore use futures trades to hedge their normal business risks. Commercials are best thought of as hedgers who want to minimize their exposure to potential gold moves and use futures to offload price risk to willing speculators.
Non-commercial traders do not meet the guidelines on hedging, they are the pure speculators. They typically do not have any business interest in physical gold like the hedgers. They are generally trading gold futures to increase their risk, to bet on price movements for a pure speculation motive. Since all a futures market ultimately does is transfer risk from the risk averse to the risk seeking, hedgers are the risk averse and non-commercials, or large speculators, are the risk seeking.
The final, and much smaller, group is the non-reportables. These are gold futures traders that deal in such small volumes of contracts that they are not subject to formal reporting requirements. This group is the small speculators, people like you and I who either dabble in gold futures or consistently deploy positions under the reporting threshold.
So in the futures world, long and short is only relevant relative to these three groups of hedgers, large speculators, and small speculators. While total longs and shorts are always equal, sometimes one group has more long positions than short or vice versa. Over time we can chart the net long and net short positions of each CoT group and glean some valuable insights on gold.
Our next two charts look at the composition of gold futures positions between these three groups over the entire secular gold bull. Two popular theories, both bearish, are immediately obliterated by this strategic view of the gold futures scene.
One of the most common bearish CoT arguments I hear is the dangers in the commercials being heavily short. If one is not familiar with the futures markets it is easy to see how this idea can spook investors. In reality though, as this chart shows, there is nothing new or anomalous about the hedgers taking the short side of the gold futures trades.
In fact, for the entire gold bull to date the net short position of the commercials has been rising relentlessly yet gold still powered from $250ish to $450ish! If you had believed the naysayers who I remember well from 2001 that claimed at that time that the commercial shorts meant gold was capped and could not rise, then you would have missed the entire gold bull to date. The logic behind fear of commercial shorts is just as flawed today.
Remember that commercials are hedgers, they are usually involved with physical gold in some way and have business risks directly tied to it. In miners’ cases, they dig up gold and sell it. They can wait to sell it until it is actually mined and refined into rough dore bars or they can try and lock in today’s prices for actual future sales. Now even if you loathe producer hedging as much as I do, the underlying logic is still easy to understand.
Gold miners, just like us mere mortal speculators, cannot know the future gold price in advance. Yet, they have very high fixed costs that they have to pay. If they fear gold may go lower, even if only for a temporary correction, they may want to sell gold at higher prices today for delivery six months from now. They accomplish this risk management by selling a gold futures contract. They are “short” but they have or will soon have the physical gold to deliver.
This forward selling allows them to lock-in future cash flows and pay their employees. While I am an outspoken opponent of bull-market hedging by gold producers and will only own companies who have low or no hedges, I can still understand why decisions to lock in today’s prices are made. These commercial hedgers are not necessarily shorting gold to manipulate its price lower, they are just selling gold tomorrow at today’s prices to better forecast their operating cashflows.
Hedging is common in all commodities businesses. This is the stone-cold reality regardless of one’s philosophy on it. And since the futures market is a zero-sum game, the only reason that you or I can even go long gold futures is because some other counterparty, probably a hedger, is willing to sell them to us. The higher the gold price goes, the more hedgers will try to lock in prices and the higher their net shorts will rise. This is natural and expected, hedger forward sales are nothing new.
The second misleading theory that this chart dispels is the notion that small speculators are getting euphoric on gold. If I had an ounce of gold for every time someone e-mailed me and told me that the little guys are just too bullish, I could probably launch my own private central bank!
The red line above highlights the evolving net long position of small speculators, individuals like you and I playing the gold futures market. The bull-to-date high of net longs for small specs happened way back in early 2003 when gold first hit $375. Interestingly, back at that time sentiment was too euphoric and a 200dma pullback was due and expected.
Since early 2003 though, the trend of small spec net long positions in gold futures has been down. Yes down, you read that right! If the net long position in gold futures by small speculators is a valid indication of popular euphoria, then gold sentiment is no more euphoric today than its was way back in late 2001. For nearly four years now small spec net longs have generally hovered between 25k to 50k contracts. The thesis that gold is in a small-investor-driven speculative mania could not be farther from the truth!
Meanwhile net long positions by large speculators are gradually growing as the secular gold bull marches on. Once again, not surprisingly, this is normal and expected and is not the least bit bearish.
All speculators start small, and it is only the successful ones that survive long enough to build up considerable capital. By the time they reach the big time, they have made all the usual mistakes that speculators are wont to make and they have grown quite sophisticated. Many large speculators could not care less what they trade, they only want to be where the action is. If the bull market is in stocks they will trade the index futures, but if the bull market is in commodities they will funnel some capital into gold.
These large speculators have learned to ride long-term secular trends. In gold’s case, the longer it powers higher for fundamental supply/demand reasons, the more large speculators want to pile on. Riding secular trends is probably the safest way to multiply a fortune since it doesn’t rely heavily on ultra-short-term trading savvy or luck. As such, the longer gold moves higher the more capital large speculators will throw at it to ride its bull market. Momentum always attracts capital.
The bull-market economy among futures traders is pretty standard, and gold futures look just as they ought to. In general hedgers lock in prices for their production to stabilize their cashflows, taking the short side of trades. Large speculators come in to ride the primary trend and take the long side. Meanwhile small speculators pick up the long crumbs the large specs leave on the table.
Our final graph zooms in on only the last few years or so, increasing the resolution of the latest gold futures action. It reinforces the CoT interpretation that this gold bull’s futures signature looks like any typical futures bull market and there is nothing bearish or anomalous to fear.
In all these charts the major interim tops in gold are highlighted by the vertical transparent blue bars. I found it fascinating here to compare the hedger net short position with the major interim tops in gold. In general, the hedgers had the most net shorts outstanding just when gold was hitting major new bull-market-to-date interim highs. This shows some impressive trading savvy among the commercials.
Love or hate hedging, the commercials were attempting to lock in their selling prices near the interim highs. In some cases, in hindsight at least, this could even be beneficial to shareholders. For example, just as 2004 dawned commercial shorting neared a bull-to-date record level. It turns out that gold traded as high then as it would for the next ten months or so. So theoretically a hedger with impeccable timing could have sold gold futures in early 2004 and received a better price for its gold over the next ten months than a non-hedger.
Meanwhile the small speculators, the group that is supposedly crazy euphoric for gold today, has maintained roughly the same level of net long exposure to gold for over three years now! Bull markets climb a wall of worries and small specs continue to worry and fret today just as they have for this entire bull to date. They are the most emotional of all futures traders and their enthusiasm is waning, not skyrocketing. This pessimism or skepticism is a bullish contrarian sign.
The bottom line is the gold futures Commitments of Traders report, considered in strategic context, does not support the main bearish theories floating around bearing its name today. The gold futures signature looks like most bull markets’ futures signatures generally do. There are no obvious anomalies.
Gold sentiment is rotten today only because the gold price has been weak. As I discussed last week in the context of gold stocks, it is always price action that drives prevailing sentiment. Yet, dire sentiment itself along with relatively low prices near gold’s linear support and 200dma is one of the surest signs of a major interim bottom. If historical precedent remains a valid guide, gold is due to rally dramatically from these lows, not sink into oblivion.
If you are interested in trading the probable approaching gold upleg, we have been gradually redeploying into elite unhedged gold stocks in our acclaimed Zeal Intelligence monthly newsletter in recent months and will continue to do so as market conditions allow. Please join us today! Great profits await if the gold bull continues higher as its fundamentals, technicals, and futures CoT suggest it ought to.
Any prevailing fear running rampant today based on the gold futures CoT is simply not supported by the underlying data.
Adam Hamilton, CPA April 15, 2005 Subscribe at www.zealllc.com/subscribe.htm