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With gold forging glorious
new record highs (in nominal terms),
traders’ interest in this metal’s 8-year-old secular bull is ballooning
rapidly. And like most commodities, the lion’s share of gold trading
happens in the futures markets. So the tactical gold-price action at any
given moment is usually dominated by futures buying and selling.
Knowing this, traders often
scour futures reports to look for insights into gold’s current price
trend. Is it likely to be sustainable long enough to profitably trade, or is
a reversal imminent? While there is endless futures data available for
analysis, the granddaddy of all futures reports is certainly the Commodity
Futures Trading Commission’s Commitments of Traders Report.
The CFTC’s CoT,
released each Friday with data current to the preceding Tuesday, is a
devilishly-complex document. The aggregate futures CoT for 2008 alone has 126
columns of data, 5631 rows, and weighs in near 5mb in Excel
format! Analyzing this beast is certainly not easy, which is probably
why very few traders undertake this themselves. They generally wait for
professional analysts to decipher and interpret it.
The CoT’s inherent
complexity has cloaked it in something of a mystic awe. Since it is so
time-consuming to understand, a kind of priesthood has sprung up to translate
it for the masses. As with any small group holding seemingly impenetrable
esoteric knowledge, entirely too much credit is given to this
priesthood. Unfortunately most traders simply accept professional
analysts’ CoT interpretations without question.
This is certainly true in the
gold market. Having actively traded gold since this bull began in early 2001,
I can’t even count the number of times I’ve read comments like
the following. “Gold open interest fell by 10,000 contracts, the smart
money must be getting out.” “Commercials’ record
short position is capping gold, it is going to fall.” Note that each
statement starts with fact, but concludes with mere opinion.
After having studied the
weekly gold CoT numbers on and off for many years now, personally I don’t
find this information useful at all for my own profitable trading. At best,
the CoT reports are a minor secondary gold-price driver and even then very
infrequently. But since the CoT priesthood’s interpretation of this
complicated report can definitely sway prevailing psychology from time to
time, traders need to understand it.
According to the CFTC, the
precursor to the CoT was born in 1924 when the Department of Agriculture
started publishing annual reports on hedging and speculation in grain
futures. In mid-1962, the modern CoT era began when monthly reports were
issued for 13 agricultural commodities. More futures were gradually added
over time. The CoT started to be published twice a month in 1990, and
weekly in 2000.
Prior to 1995, the CoT was
only available by paid subscription. I suspect this really added to its
mystique. Newsletter writers would buy this complex difficult-to-understand
report, try to interpret it, and then sell the results in their newsletters.
A letter writer really appeared to be in-the-know if he could wade through
the deep waters of the CoT and formulate trading strategies based on it. But
today it is freely available to all on the CFTC’s website.
While there are more esoteric
metrics in the CoT like concentration ratios (how few traders are holding
futures), most analysis today concentrates on a couple key metrics. The
first is open interest, or how many futures contracts are
outstanding. The second is how these open contracts are divided among
three classes of traders. Many myths have sprung up around both metrics that
mislead traders.
This first chart details the
open interest in COMEX gold futures since 2001, the year this secular gold
bull stealthily started steaming higher. Open interest is measured in contracts,
and each contract represents 100 troy ounces of gold. Since CoT data is only
available once per week, all this gold price data is weekly too. In
order to understand gold futures open interest, this number’s
historical context is utterly crucial.
The blue line is the weekly
gold price, and the red line is the weekly gold futures open interest
directly from the CoT. Digesting this chart will give you context to help
evaluate the priesthood’s interpretations of developments in OI. For
example, back in mid-2001 when there were only 100k contracts of gold
trading, a 10k swing in one week was a big deal (10%). Today with 450k
contracts, this same 10k swing is pretty trivial (2%).
Note that OI has trended
higher on balance over this entire gold bull. This is the first key lesson of
CoT analysis. As any bull matures, as any price marches ever higher, it
attracts more traders and more capital. This is a core tenet of the financial
markets in general. Nothing begets more interest in an asset like
relentlessly rising prices. This dynamic forms the virtuous circle that
drives all secular bulls higher.
Back in May 2001 when I first
recommended buying physical gold coins as a long-term investment in my monthly
newsletter, I was ridiculed. Gold was in the mid-$260s and had languished for
decades. Even in the contrarian circles in which I traffic, few wanted to
touch it. But over the years as gold’s price meandered higher, more
traders grew interested as expected.
They bought, driving the
price even higher, which caught the attention of still-wider populations of
traders. Then they too bought, strengthening the virtuous circle. And lo and
behold today gold is generally accepted over $1000 when it was universally
loathed at a far-superior entry price under $300 some 8 years ago. Bull
markets are magnetic, they attract in increasing numbers of traders and
capital over time.
So for gold futures OI, we
should expect this number to continue to grow on balance until
this secular gold bull gives up its ghost. That won’t happen until
gold’s global supply-and-demand fundamentals
turn bearish, virtually impossible for many years yet. Gold’s OI grew
in a tight secular uptrend for years, until the commodities surge starting in
late 2007 and stock panic
in late 2008 temporarily blew it out of trend.
This shatters a common OI
myth from the CoT priesthood, that record-high gold OI is always bearish for
gold. In its mild form, analysts claim record gold OI levels warn of an
imminent pullback or correction. This is certainly true at times. But
in its extreme form, I’ve heard analysts claim some particular OI
record means this secular gold bull is coming to an end. That is just
nonsense. Check out the OI records above compared with gold itself.
Sometimes, record-high OI
does precede a correction. Early 2003 and early 2008 are great examples of
this. But other times, despite record OI gold soars higher. In
mid-2007, gold OI first approached 425k contracts. I remember well CoT
analysts at that time claiming gold had to correct hard because OI looked
frothy. Yet from those $675 levels, gold soon soared to $1000 in early 2008
(and gold OI went even higher).
Usually OI does rise when
gold is strong, which makes sense. Rising prices attract in more futures
traders looking to ride the rally. But this is certainly not always the
case. One of gold’s strongest uplegs of this bull ran from late 2005 to
mid-2006, from roughly $425 to $700. Yet during what was the best run in the
entire bull to that point, gold OI stayed flat.
While the principle of higher
gold prices leading to greater gold futures open interest is true, at a
tactical level this really isn’t particularly useful for
trading. Why? First, gold OI usually runs concurrent with the gold
price. So if OI is contracting, odds are gold is already falling. The
price itself already gave traders all the warning they need. Second, there
are plenty of exceptions in this bull where gold OI did its own thing and
ignored gold.
So next time an analyst makes
a statement like “gold open interest soared (or plunged) 10,000
contracts”, keep a few things in mind. The actual number of contracts
is irrelevant since OI is growing on balance. Convert the raw number into a
percentage, which is meaningful. The bigger the percentage gain or loss, the
greater the potential relevancy of the swing. But no matter how large
the swing, at best OI moves with gold and hence offers no lead
time to traders. And there are plenty of exceptions to this concurrent rule,
when OI decouples from the gold price.
Although the
priesthood’s often-poor interpretations of OI swings mislead many
traders, the confusion created by the classifications of traders is at least
an order of magnitude greater. There is a small but vocal minority of
analysts who are unbelievably paranoid about who is holding which futures in
the gold market. Sometimes I wonder if this aspect of the gold CoT is a
bigger bogeyman than central-bank gold sales.
The CoT breaks futures
traders into two major categories, with any excess spilling over into a third
smaller plug category. On the actual reports, these are known as
non-commercial traders, commercial traders, and nonreportable positions.
These are easiest to understand starting at the commercials, the CoT category
that constantly frightens the less-well-informed traders in the gold world.
Commercials are large traders
that are theoretically actually producing or consuming real physical gold. I
say “theoretically” because this line is sometimes blurred
through intermediaries. Commercials, since they traffic in real gold,
often choose to lock in prices. A gold miner, in order to secure a loan to
build a new mine, may be required by its bank to sell gold futures in order
to lock in and guarantee the price it will get for some of its future gold. A
futures contract simply sets a price today for a transaction in the
future.
This hedging happens on the
buy side too. A jewelry manufacturer will buy gold futures in order to lock
in the price it will pay for the raw material it needs in order to fashion
its finished goods. So don’t fall into the trap of assuming that all
commercial hedgers are always short, locking in the price for future gold
sales today. Many other commercial traders are long, locking in the price for
future gold purchases today.
The second major CoT category
is the non-commercial traders. These are the speculators, they are buying and
selling gold futures in the simple pursuit of trading profits. They have no
intention of ever delivering or taking delivery of physical gold. Like all
speculators though, they provide a valuable service to the hedgers. They keep
the gold market liquid, effectively buying the risk that the hedgers seek to
sell.
Once the commercial hedgers
and large speculators are categorized, there is a small group left that fits
neither classification. These are small traders with positions so little they
don’t have to report them to the CFTC. While the odd small-business
hedger slips in here (like a farmer selling a relatively small amount of
wheat futures as a hedge), this non-reportable group is dominated by small speculators.
The weekly Commitments of
Traders Report documents the ongoing interplay between these three
groups. Unfortunately, the relationship of commercial hedgers, large
speculators, and small speculators to the gold price is widely misinterpreted
and generally pretty misunderstood. I suspect this is because the
CoT’s numbers are often discussed without considering how futures
markets actually work.
Futures trading is a strict zero-sum
game. Every dollar one futures trader earns is a dollar lost by
another futures trader, a direct transfer. The reason futures exchanges exist
is to strictly enforce trading to ensure each trader has the means to bear
any losses incurred. And as a zero-sum game, every futures contract is
between two traders. One trader takes the long side while the other takes the
short side of the same contract. Thus total longs and shorts are always
perfectly equal!
While longs and shorts always
balance out over gold futures as a whole, across the three categories of
traders net positions vary. For instance, in the latest CoT
report, large speculators (non-commercial traders) had 253k long contracts
and 22k short contracts. If shorts are subtracted from longs, the large
speculators are “net long” 231k contracts. And if this group is
net long, another has to be net short. And this is
virtually always the commercial hedgers.
This next chart looks at the
net positions in gold futures held by the three groups of traders over this
secular gold bull. Large speculators are rendered in orange, small speculators
in red, and commercial hedgers in yellow. And as a zero-sum game, with longs
and shorts always being equal over the entire gold-futures realm, if you add
all three groups’ net positions together for any given week you will always
get zero.
The group the CoT priesthood
is always using to mislead traders is the commercial hedgers, so we’ll
start there. Almost constantly a small minority of analysts is lamenting some
development in the commercial-trader space leading them to believe that gold
is either going to be capped or fall sharply. The most common theme
I’ve heard over the years is “record commercial short position
bearish for gold”.
First of all talking about
“commercial shorts” is misleading alone, since it is commercial net
shorts that are relevant. Commercial longs always exist too. Anyway, this
myth that record commercial net-short positions are harbingers for an
imminent collapse in gold are particularly relevant right now. As you can
see, a couple weeks ago the commercial net-short position soared to a record
288k contracts! In early September, this number rocketed 25% higher in
a single week alone!
For the CoT priesthood, a 25%
surge in commercial net shorts in one week, to a new record high no
less, is the most bearish scenario imaginable. The noise about how the
commercials were “going to cap gold” was deafening, and with gold
already up at $994 it felt too high to many. Yet this week, just a month later,
gold had surged to $1042 by Tuesday (the day the CoT is finalized).
Obviously a record commercial
net-short position didn’t presage a sharp tumble in the gold price. And
this ties in with why CoT analysis is often so misleading. Analysts
will comment on this stuff, a 25% rise to a record in one week, but offer no
historical context. If you study the chart above, you can find plenty of
times when new record commercial net shorts did not
precede a big correction in gold.
In late 2005, commercial net
shorts surged to their 5th major record of this bull. Yet right then gold had
just launched a powerful rally that would take it from around $475 to $700.
Similarly in late 2007 commercial net shorts surged to another record,
pushing what was then an unbelievable 250k contracts. Yet gold still managed
to rally strongly from around $825 to $1000 right out of
that commercial net-short record.
While there were times when
gold did indeed carve a short-term interim high when commercial net shorts
reached a bull record, there were just as many times when gold powered on
higher despite such a record. Given this statistic’s bipolar behavior
relative to the gold price over this bull, it is simply not a
high-probability harbinger of any move. Out of the 8 records noted above,
only 4 coincided with major interim gold highs. With just 50/50 odds for
success, it amazes me that anyone still cares about this CoT metric.
Remember that futures open
interest grows as a bull matures, which is natural as more capital seeks to
deploy into the winning asset. And since every individual futures contract
has a long and short side, by necessity the net-short position of at least
one of the three trader groups has to grow along with open
interest. Therefore, as this secular gold bull continues higher, new
commercial net-short records will continue to be set.
Since every commercial net
short has an offsetting net long in one of the speculator groups, why not
look at these records from the other side of the same coin? Claiming
record net shorts is the same thing as claiming record
net longs! When speculators get excited enough about gold to drive
their net longs to new records, perhaps gold is temporarily overbought.
Pullbacks and corrections are healthy and normal within even the most powerful
bulls, they keep sentiment balanced. Periodically bleeding off excess
greed really extends the ultimate duration of bull markets.
Another problem with reading
too much into the perpetual interplay between these three groups is the lines
between them are blurred and arbitrary. For example, imagine a Wall Street
bank has clients it trades for that include gold miners (commercial hedgers)
and pure speculators. And this bank trades in its street name, as is
common. Does the CFTC classify this bank as a commercial hedger or large
speculator? And of course this classification can change over time for
individual traders or aggregators like banks.
I suspect the CFTC’s
delineation of these groups is woefully inaccurate and constantly in flux.
And if the groups aren’t accurate, or even consistent over time, then
looking at their net-long and net-short positions is even less relevant for
traders. Once again, the CoT data isn’t anywhere near as useful for
real-world trading decisions as the priesthood likes to imply to its
followers.
The bottom line is gold
futures activity as chronicled in the CFTC’s Commitments of Traders
Report is often misunderstood. A minority of analysts choose to interpret
facts about week-to-week developments out of the illuminating context of
bull-to-date behavior in similar situations. Thus their interpretations
of this complex report are often misleading. And sadly many newer traders are
swayed by this shoddy analysis.
It is critical to remember
gold futures are a zero-sum game. For every short, there is an offsetting
long. So if the feared commercial hedgers’ net-short position is
surging and hitting records, then so too are speculators’ net-long
positions. And as we’ve seen since 2001, as this gold bull powers
higher interest in gold futures continues to grow. So we’ll continue to
see many new gold CoT records in the years to come.
Adam Hamilton, CPA
Zealllc.com
October 9, 2009
Also
by Adam Hamilton
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