By Adam Hamilton
Gold has been deeply out of favor lately, languishing in its usual summer doldrums. This sentiment wasteland is driving traders to flee wholesale, including the futures players. Their mass exodus from the gold market is readily apparent in futures data. But provocatively such behavior is a powerful contrarian indicator, heralding the birth of major new uplegs in gold. Bearish futures traders are a bullish omen.
This truth is easily demonstrated through the granddaddy of all futures reports, the Commodity Futures Trading Commission’s Commitments of Traders. The giant CoT is released every Friday afternoon, with data current to the preceding Tuesday. It details the futures positions currently held by several classes of traders in nearly all US futures markets. When analyzed over time, these yield many trading insights.
The most basic piece of data the CoT reports is open interest, or the total number of futures contracts currently held by traders. Each contract is a single trade between two individual traders, one betting the underlying price will rise (long) with the other betting it will fall (short). Before the contract expires, it will be settled with cash flowing from the trader who bet wrong to the trader who bet right. This closes it.
As you can imagine, open interest is generally correlated with the popularity of the underlying market. When a price is rallying and generating excitement, trading activity in that market usually swells as traders rush to participate. But when a price is falling or drifting, demoralized traders gradually abandon that market to seek greener pastures elsewhere. So open interest directly reflects prevailing sentiment.
In gold, each futures contract represents 100 troy ounces. So with this metal trading around $1600, each contract controls big money. If you multiply the gold-futures open interest by 100 ounces and the gold price, it gives you an idea of how much capital futures traders are risking in gold at any time. Like any market, the better that gold is doing the more capital flows in to chase these gains. And vice versa.
This first chart looks at the CoT’s open interest for gold futures since 2001, when gold’s current secular bull was born. The gold price is superimposed in blue. Since the CoT is only published weekly, the gold data is sifted through the same weekly filter. Low open interest in this metal, like we are seeing today, is very bullish. When futures traders wax too bearish and give up on gold is exactly when we want to buy it.
Gold open interest has been in a strong secular uptrend since 2001, which makes sense. The longer gold’s bull persists, and the higher it drives gold’s price, the more traders are interested in participating in this market. Nothing attracts capital like rising prices, which soon form a virtuous circle. Traders buy gold because its price has risen, and their buying pushes it even higher, which entices in still more traders.
For the great majority of gold’s bull, its futures open interest has meandered within the uptrend channel rendered on this chart. A couple times it broke out above resistance after powerful gold uplegs sparked exceptional excitement in the yellow metal. But as you can see, these upside breakouts were short-lived. Gold soon corrected, bleeding off excessive greed which led open interest to collapse back into trend.
And a couple times open interest broke down below support. The first was during 2008’s once-in-a-lifetime stock panic, where even gold got sucked into that extreme fear maelstrom. All anyone wanted was cash, even gold wasn’t good enough for most during that epic selling event. But the sub-support journey of gold open interest was short-lived, it soon surged back up into trend in 2009 as gold recovered.
Today gold-futures open interest has once again fallen below its uptrend’s support. Back in late April it actually plunged to its lowest levels since September 2009, when gold was trading near $955. While futures traders have driven a slight uptick since, open interest is still very low relative to recent years. And this very phenomenon has proven wildly bullish throughout gold’s entire secular bull.
I highlighted similar gold-open-interest lows with red bars on this chart. When open interest falls far enough to hit its secular uptrend’s support, or is dragged even lower occasionally, this psychological ebb marks the birth of major new uplegs. When futures traders are the most bearish or apathetic about gold, giving up on it, is exactly when this metal is transitioning from correction or consolidation to upleg mode.
Back in early August 2005, gold-futures open interest collapsed to 244k contracts. Since 2003, gold had been trapped between $400 to $450 or so. And after any long consolidation, a sideways grind with no new upside, traders capitulate and walk away. But as you can see above, gold soon launched a mighty rally out of those summer doldrums. By May 2006 it was trading way up near $700 on a weekly basis.
These summer doldrums are actually very important today. Global gold demand spikes are very lumpy, driven by income-cycle and cultural factors around the world that always arrive around the same times of any calendar year. The only period totally devoid of big gold demand spikes is summer, leading this metal to grind sideways this time of year. Gold usually drifts lower, driving widespread capitulation.
But out of these summer-doldrums lows likely in late July or early August, gold’s big seasonal autumn rally launches. Traders who can fight the crowd and buy low in late summer when everyone else has given up usually win big gains in gold’s following strong season. And when other indicators like gold-futures open interest are also bullish at this same time frame, gold’s odds for a large rally balloon.
Gold corrected sharply after that May 2006 peak, leading open interest to collapse as futures traders fled. On a weekly basis this metal fell back down under $565 as open interest hit support. White it wasn’t a great time to buy seasonally, gold still recovered back up to its recent highs after that open-interest support approach. The next major one wasn’t seen until August 2007, a great time to buy seasonally.
Right as futures traders were giving up on gold and moving on, it started surging to major new bull-market highs. This metal rocketed from around $655 to $950 on a weekly basis by February 2008. Once again the brave contrarian traders who could step in and go long gold when the futures traders had given up on it were richly rewarded. Later that year the crazy stock panic arrived, universally eradicating bullish sentiment.
While gold-futures open interest’s secular support line didn’t hold in such an extreme fear superstorm, their trough still coincided closely with gold’s major bottom. By December 2008 open interest had plunged to 261k contracts as gold was trading near $775. But gold had just begun a huge upleg that would ultimately carry it to $1400, a new all-time nominal high, by December 2010. Futures traders were wrong to flee.
A correction in early 2011 drove a plunge in open interest again as futures traders freaked out. But gold soared from around $1340 at that open-interest ebb in February 2011 to nearly $1880 by September 2011. As you can see, when futures traders give up on gold so open interest falls to support or below have proven fantastic times to go long this precious metal. Buy when the futures guys refuse to.
Which brings us to today. Gold-futures open interest was recently almost as far under support as it was during the stock panic in late 2008! That was the only other time in this entire secular bull when open interest bled far enough to hit multi-year lows. And after that earlier episode of futures abandonment, gold’s greatest upleg of its entire secular bull began marching higher. Contrarian traders like our subscribers earned fortunes.
Will a similar mighty upleg accelerate in the months ahead? Probably, as the data is crystal-clear in showing that when futures traders get discouraged in gold and pare their bets is right when major new uplegs launch. Today’s low open interest relative to recent history implies poor sentiment. And bearish psychology sucks in all near-term sellers, leaving only buyers. So it is the spawning ground of major uplegs.
The Commitments of Traders report goes way farther than simple open interest though, dividing traders into three distinct categories. These are technically known as commercial traders, non-commercial traders, and nonreportable positions. Observing over time how gold-futures positions shift among these classes offers even more insights into where the metal is likely heading in the near future.
The single-most important thing to remember about futures is they are a zero-sum game. A gold futures contract cannot be created until both a long-side trader and short-side trader are found. Any money won by one side of the trade is a direct cash loss by the other side. Every long has a corresponding short counterparty. Thus the total number of longs and shorts is always perfectly equal, they exactly offset.
But within these three categories of traders, net-long and net-short positions emerge. If the commercials are mostly short, the non-commercials are mostly long. A sizable cottage industry has grown up over decades attempting to explain the futures interactions across these groups, and use them to attempt to divine future price movements. But CoT trader-category analysis certainly doesn’t have to be complex.
The commercials are large traders who are actually producing or consuming the underlying commodity. In gold they include miners and jewelry manufacturers. They generally use the futures markets to hedge, to lock in selling prices (producers) or buying prices (consumers). The only reason they even have this option to hedge is because speculators are willing to take the opposite side of these futures contracts.
The non-commercial traders are large speculators who are solely in the game for trading profits. They neither mine gold nor use it in products. The nonreportable positions are small speculators, who also have no need to take delivery of gold. In pursuing their own profits, these two groups of speculators provide a great service to the gold market. Their liquidity is essential to keeping it functioning efficiently.
This next chart looks at the net-long and net-short positions among all three categories of traders. While there is some controversy about how these boundaries are drawn (is a particular trader a hedger or speculator?), the raw data is still useful for traders to consider. Just like with open interest, there are particular changes in the net-long-net-short gold-futures distribution characteristic of major bottomings.
As you can see, throughout this entire secular gold bull the commercial hedgers have always been net-short. And this makes business sense. As gold gradually hit new highs over the last decade, its producers chose to lock in their selling prices in case those highs didn’t last. Sometimes the miners themselves wanted to hedge, and other times banks forced them to hedge in return for project financing.
Of course in a secular bull investors hate hedging, and expect gold to keep powering higher on balance indefinitely. The longer a bull lasts, the more traders extrapolate the move continuing indefinitely. So speculators, both large and small, have eagerly taken the offsetting long side of the hedgers’ price-lock trades. They are eagerly willing to accept the price risk the producers and consumers want to offload.
Hedgers generally aren’t trying to time the gold market, they are locking in prices via gold futures for business reasons that have nothing to do with uplegs and corrections. New gold mines often take a decade or more to come to fruition, and when they need to be hedged to win financing has nothing to do with short-term psychology. But speculators, on the other hand, are dominated by gold’s sentiment.
Since it is these guys collectively trying to time gold, they act as a contrarian indicator. Like all traders, they get the most excited and greedy after gold has already rallied and is hitting a major peak. And they get the most discouraged and scared after gold has already corrected and is bottoming. Prudent contrarian traders can capitalize on this groupthink herd mentality to buy gold cheap before major uplegs.
Generally in CoT analysis, the small speculators are considered the best contrarian indicator. They have less experience, capital, and sophistication than large speculators. But as this chart shows, most of the times that small speculators have the smallest net-long position (therefore they are the most bearish) the large speculators concur. I highlighted some of these bearish ebbs for the small speculators in red.
As open interest naturally grew throughout this secular gold bull, so did the net-long and net-short positions among the trader groups. So there is a support line for the large speculators and their longs and a mirror-image one below for the hedgers and their shorts. When the large speculators scale back their net-long bets enough to hit this support line, it is usually right on the verge of a major gold upleg.
You can see these episodes above, in late 2006, mid-2007, late 2008 during the stock panic, and again this summer. After each of these past episodes where speculators greatly reduced their net-long positions because they didn’t think gold was going anywhere, gold soon started rallying or even surging. Huge uplegs were born out of the last two episodes in mid-2007 and late 2008, gold soared to new heights.
Like most traders, futures guys give up at exactly the wrong time. They pare their long-side bets the most after gold has either corrected sharply or drifted sideways long enough to convince traders it is doomed to languish indefinitely. Such episodes of despair motivate all weak hands interested in selling anytime soon to dump their positions, which leaves only buyers. So out of such bearishness new uplegs are born.
And once again this summer, the net longs of large speculators and even the net shorts of hedgers have fallen nearly as far below their respective support lines as they did during 2008’s stock panic. Small speculators’ net longs are back to 2009 levels, with a major multi-year low recently seen. Hardly anyone is the least-bit bullish on gold today, instead bearish and giving up on it after its long consolidation over this past year.
The last time this kind of sentiment was seen after the stock panic, gold was just launching its biggest upleg of this entire secular bull! I suspect we are on the verge of another large upleg now, as the capitulation and despair today is the perfect breeding ground for one. When futures traders are the least bullish on gold is when we should be the most bullish. They always get it wrong at major bottoms.
At Zeal we are ramping up for this coming major upleg in gold, which may already be underway. The terrible sentiment in gold reflected among futures traders has driven amazing bargains in gold stocks, silver, and silver stocks. So we are building up our precious-metals-stock trading positions ahead of the seasonal autumn rally. Gold is perfectly positioned to soar dramatically this year for a variety of reasons.
The bottom line is futures traders’ recent ebb in gold trading is a very bullish omen. They have given up on gold because it has corrected and consolidated for too long, with speculators dramatically reducing their net-long positions. This has dragged down gold-futures open interest as these traders walk away to seek opportunities elsewhere. This is a reflection of bearishness, despair, and capitulation in gold.
But out of similar conditions in the past, the mightiest uplegs of gold’s entire secular bull have launched. When futures traders capitulate and abandon gold is exactly the time to buy. Like traders in general, they are a fantastic contrarian indicator. They get greedy and bullish at major tops and scared and bearish at major bottoms, the exact wrong times. Today’s sorry state of gold-futures trading means this metal is ready to surge.
Adam Hamilton, CPA
July 27, 2012
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