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Many who hope to succeed in the markets seem to forget one of the primary laws of market speculation: Sutton’s
Law. This axiom has proved
correct time after time and is
now used in several disciplines, ranging from law enforcement,
physics, medicine, economics and market speculation. Sutton’s Law
is described precisely by its namesake, William “Willie” Sutton, the prolific 1920’s bank robber who, when
asked why he robbed banks
answered, “That’s
where the money is.”
In the teaching of medicine,
Sutton's law states that when diagnosing,
one should first consider
the obvious. Likewise,
the FBI investigator puts
a premium on physical evidence
when building a case. Even
the garage mechanic will
check for fuel in the tank of the car that refuses
to start before proceeding further. Sutton’s Law also applies to successful market speculation, where and important key is following the flow of smart
money-- “where the smart money is”
So how can
one determine where the
smart money is going?
Well, one way is to follow the tape.
That is,
the ticker will show price movement, up or down, for
a given traded good. And the volume of trades
pushing prices up (more buyers than sellers)
or down (more sellers than
buyers) is a primary indicator of market sentiment (bullish or bearish) and future market
direction. But, markets reverse, and there is the rub. Price action can reverse
in minutes or over months. So how can the speculator profit given the fickle nature of the markets? One way that has proved itself over time is to apply Sutton’s Law: go to
where the smart money is.
In the commodities market,
we can see where a big
chunk of smart money is flowing by using indicators based on the CFTC Commitment of Traders (COT) data. So let’s
examine the case for trading gold with the aid of COT data.
The Commodity
Futures Trade Commission publishes trade data by the major players
in the commodities market.
These are 1) Large Speculators,
professional fund
managers and institutional traders, 2) Commercials, the industrial producers of the commodity, and
3) Small Speculators, private
investors that speculate in commodities. Large
Speculators tend to follow
the market trends. Commercials
tend to hedge, or bet against the trend in order to reduce price volatility risk. Small Speculators tend to follow
trends as well. The Commitment
of Traders data is collected
weekly after the close on
Tuesday and the Commitment of Traders Report is published after the close on Friday. COT data consists
of the number of long and short contact positions
places by each of the player
segments. Outstanding contract
positions display current market
sentiment of the holder. For example,
if more Large Speculators hold
long contracts than those with short contracts, then Large Speculator sentiment is bullish. Commercials are typically on the other side of Large Speculator trades, so Commercials
tend to be short when
Large Speculators are long.
We can see the disposition of each player in the gold market as of
last Tuesday in the chart below.
The bars above the zero
line represent net long positions; bars below the line are net short positions. We can see
that Large Speculators
have been increasing long positions in gold over
the last month. At the same time, Commercials have purchased more short contracts.
We can also see that
Large Speculator bullish
sentiment has moved up 4 points from
last week to 87%.
This is useful information to keep in mind, but as my friend Jim Cramer would say, “Fine, but can you trade with
it?”
Well, it turns out that COT data can provide very
good trading information. The predictive
property comes from movements of the COT
Index. The COT Index is the net position of each of the major players
(Large Speculators, Commercials
and Small Speculators) over a 26-week period. As such, it is similar
to a moving average. Changes in the COT Index tend to predict future price action.
This is because Large Speculators tend to be trend followers and good market timers, and Commercials tend to
be good at hedging against future market movements. We can see
this dynamic playing out in gold in the chart
below, which shows movement in the COT Index at
the bottom.
We can see the COT Index for the Large Speculators
(called Large Traders here)
by the green line, and Commercials, the blue line. The COT Index represents
net position change, so its
scale is 0 to 100 percent. As expected, the COT
Index for each displays the inverse relationship to one another. What’s important is the when major changes take place.
For example, back in February,
the Large Traders began to go long. We can see
the price gold climbed in
February to March. The Commercials,
anticipating higher gold prices, loaded up on short contracts over the same period. In April, Large Traders added
new long contracts, while
the Commercials shorted some more. Gold surged to over
$1550/oz by May. In late June,
Large Traders dumped their
long contracts, and Commercials
went long. Gold dropped
$50. In early July, the Large Traders went long in a big way; the Commercials shorted in turn. Since then gold has jumped to over $1660/oz.
Investors from around the world benefit from timely market
analysis on gold and silver
and portfolio recommendations contained
in The Gold Speculator investment
newsletter, which is based on the principles of free
markets, private property, sound money and Austrian School economics.
Scott Silva
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