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Gold-Futures Short Covering

Adam Hamilton
Apr 10, 2015

Gold's bottoming consolidation grind continues, with investment demand still garroted by sky-high world stock markets and the parabolic US dollar. With investors missing in action, gold prices remain totally at the mercy of American futures speculators. These perpetually-bearish traders are once again heavily short gold, which has led to sharp short-covering rallies in recent years. The latest one has just started.

In normal markets, gold prices are determined by global investment demand. This certainly isn't the biggest source, running at just under a quarter of world gold demand last year according to the World Gold Council. But it's the most volatile by far, changing dramatically with the shifting winds of investors' favor for gold. When they want to diversify into gold, their extra buying inexorably pushes gold prices higher.

But unfortunately the last couple years have been anything but normal for gold. Back in early 2013, the Fed started augmenting its young QE3 debt-monetization campaign with aggressive jawboning. It kept implying to stock traders that it was ready to quickly ramp up money printing if the stock markets sold off materially. This short-circuited normal healthy sentiment-rebalancing selloffs, as traders feared nothing.

Since they figured the Fed had their backs, why even worry about such trifling things as dangerously-high valuations and radical overextension? Thus the stock markets levitated, powered higher without normal material selloffs. Since gold is an alternative investment that moves contrary to stock markets, this slowly strangled gold investment demand. Investors gradually abandoned it, leaving this metal for dead.

Their absence left gold prices utterly dominated by American futures speculators. Because of futures' inherent extreme leverage, a relatively small amount of capital has a wildly-disproportionate impact on price action. While investors usually buy gold outright, or at most run 2x margin through gold-tracking ETFs like the flagship American SPDR Gold Shares (GLD), it takes far less capital to game gold via futures.

Each COMEX gold-futures contract controls 100 ounces of gold, which was worth about $120k with gold meandering around $1200 this week. But the minimum maintenance margin required to own that single contract is merely $4k. That means American futures speculators can run extreme 30x leverage to the gold price! That is incredible, as leverage has been legally limited to 2x in the stock markets since 1974.

With each dollar of futures speculators' capital controlling up to $30 of gold, their trading naturally has a super-outsized impact on gold's price. Every dollar they deploy effectively has 15x to 30x the price-moving firepower of an identical dollar invested! That's a powerful force even in normal times, and with the Fed frightening away investors in recent years futures trading has become overwhelmingly dominant.

This first chart really illustrates this. It looks at the daily gold price superimposed over speculators' total gold-futures positions as reported by the CFTC in its famous weekly Commitments of Traders reports. Large and small speculators' total long gold-futures positions are shown in green, and their short ones in red. And it is their short selling in particular that has manhandled gold in these surreal Fed-distorted markets.

The strong inverse correlation between the gold price in blue and speculators' total gold-futures shorts in red is nearly perfect in recent years. When speculators are effectively borrowing gold they don't own to sell it in the futures market, the gold price falls. Then later when they fulfill their legal obligations to buy back those same shorted contracts to cover and close them, the gold price rallies. Like clockwork!

Provocatively that's the lion's share of gold's pathetic story in recent years. With investors largely gone thanks to the Fed, American futures speculators' short selling effectively controlled the gold price. This metal hit major lows when their short-side bets were high, and major highs when their shorting was low. While other factors like epic record gold-ETF liquidations came into play, futures shorting dominated gold.

Given this ironclad precedent, it's very clear there's nothing more important to watch for investors and speculators looking to game gold. At least until these lofty artificial Fed-levitated stock markets inevitably roll over and restore some semblance of normalcy. As long as the majority of investors shy away from gold, American futures speculators will continue running amuck with its price. They've got the helm.

So it's absolutely essential to follow their gold-futures short selling and subsequent covering to gain the best idea of where gold is likely headed next. And speculators' total gold-futures shorts recently soared to a major high. As of the second-to-last CoT report before this essay was published, speculators' total shorts climbed to an enormous 150.6k contracts! That is a massive amount of gold borrowed and sold.

With each futures contract controlling 100 ounces of gold, 150.6k contracts is the equivalent of 468.4 metric tons of gold. To put this into perspective, in all of 2014 global gold investment demand was just 904.6t. So American futures speculators, just one group of traders in a big world, have borrowed and sold the equivalent of over half an entire year's gold investment demand! No wonder gold has been weak.

This is actually the third-largest spike of speculator gold-futures shorting on record. Our Commitments of Traders data at Zeal goes back to early 1999. And over the entire span since, there have only been two other episodes of more extreme speculator shorting. The big one was back in early July 2013, after gold had just plummeted 22.8% in the second quarter of that year. That was its biggest quarterly loss in 93 years!

What was essentially a once-in-a-century extreme gold selloff was driven by a combination of extreme gold-futures shorting and extreme gold-ETF liquidations. That ill-fated disaster of quarter initially saw panic selling as gold's major multi-year support failed. Another brutal leg down happened a couple of months later when Ben Bernanke started talking about the Fed slowing down its QE3 bond buying.

The resulting epic bearishness led American futures speculators to ramp their short contracts to what was at least a 14.5-year high (since early 1999) and likely an all-time record of 178.9k contracts! That was the equivalent of 556.4t of gold. While gold's prospects certainly felt bleak back then just as they do today, speculators' gold-futures shorting is a powerful contrarian indicator. These shorts must soon be covered.

As you can see in this chart, gold bottoms near major shorting peaks without fail. And indeed these speculators soon rushed to cover after their epic shorting spree leading into mid-2013. There are two reasons why extreme shorting presages major buying. First, borrowing something from its owner to then sell it requires that debt to be repaid. So futures speculators are legally obligated to effectively do just that.

The way speculators repay their gold-futures shorting debts is to buy offsetting long contracts for each contract sold short. That erases the short, closes the trade, and effectively repays that debt. Thus every contract shorted soon reverses into perfectly-equivalent buying. And in the futures markets, the upside price impact of buying a new long contract or buying a long to cover a short is identical. It pushes gold higher.

That leads to the second reason why major buying follows big shorting, the extreme leverage inherent in futures speculation. Today's maximum margin available in gold-futures trading isn't an anomaly at all. At 30x leverage, a mere 3.3% move against a speculator will wipe out 100% of their capital risked! They face total losses, and even more with margin calls, if gold manages to stage even a relatively-small rally.

Speculators' short covering itself fuels this. As the short selling forces gold lower, some traders start to buy to cover and realize their profits. This reverses gold higher, putting other speculators' shorts at risk of rapidly becoming big losses. So they rush to cover too, sparking even more widespread buying to cover shorts. The more buying, the bigger and faster the potential losses, the quicker speculators exit.

So once short covering starts from a major shorting peak, it tends to feed on itself and unfold rapidly. After that record shorting in early July 2013, American speculators bought to cover 95.3k short contracts over the next 16 CoT weeks. That was the equivalent of an incredible 296.4t of gold purchased by this one group of traders in a matter of months. Their initial surge catapulted gold 18.2% higher in just 8.6 weeks!

Gold's short-covering rally would have been even bigger if it hadn't been retarded by the ongoing heavy differential selling pressure in GLD gold-ETF shares back then. That contributed to more bearishness on gold, so futures speculators soon started ramping their downside bets again. By early December 2013, they had soared to 150.0k contracts. Provocatively that is just under today's recent levels of 150.6k.

And that extreme shorting spree also soon gave way to major short covering. Speculators bought back 72.3k contracts in 15 CoT weeks, the equivalent of 224.7t of gold. That fueled another big 16.2% gold rally over 11.4 weeks. The best time to be bullish on gold is when American futures speculators are the most bearish as evidenced by their shorts. They will soon have to become big buyers and catapult gold higher.

The third big shorting spike of the recent Fed-distorted years crested in June 2014, but at a much-lower 132.8k contracts. Still, that resulted in 60.9k contracts of short covering in 9 weeks, helping to propel gold a very respectable 7.6% higher in just 5.6 weeks. But that young upleg was soon battered back down by the Fed's surreal ongoing US stock-market levitation and the mighty US dollar's parabolic surge.

So American futures speculators again piled on the bearish bandwagon, and ramped their total shorts to 162.5k contracts by mid-November 2014. This was their second-highest spike since at least 1999, and more than likely ever. But like all extremes of leveraged gold-futures shorting, it wasn't sustainable. As soon as gold naturally started to reverse, speculators scrambled to buy to cover. Again this unfolded rapidly.

They would buy back 92.1k contracts in the next 12 CoT weeks, the equivalent of 286.4t of gold. And that would fuel a sharp 14.2% gold rally in just 10.2 weeks. See the pattern here? When speculators get too bearish and push their leveraged downside bets too high, they will soon be forced to buy back most of those shorts which blasts gold higher. These averages prove a compellingly-bullish case for gold.

Those previous four major shorting spikes during the Fed's QE3-fueled stock-market levitation subsequently averaged 80.2k contracts of speculator short covering unfolding in 13 CoT weeks. They helped propel gold an average of 14.1% higher in just under 9 weeks. That's not trivial by any means. From prevailing $1200 levels today, a 14.1% gold upleg would blast this metal to $1369! That would really excite traders.

This crucial background on the interplay between American speculators' gold-futures shorting and the gold price brings us to today. In last CoT week's report, this group of traders' total shorts had surged back up to 150.6k contracts. That barely edged out the late-2013 shorting spike to become the third-largest on record. This meant major short covering was imminent, as I told our subscribers at the time.

And indeed it has already started. In the latest CoT week before this essay was published, speculators covered a massive 25.9k short contracts. That is the equivalent of 80.5t of gold in a single CoT week! The magnitude of this is stunning. In the 117 CoT weeks since early 2013 when the radical gold-market distortions started thanks to the Fed's QE3 stock-market levitation, only 2 others saw short covering exceed 25k contracts.

With such a massive initial short-covering frenzy, odds are this latest buying has lots of room to run. If it lives up to the previous averages after recent major shorting spikes, this portends 80.2k contracts of buying unfolding over 13 weeks. That means only about a third of the likely short covering has already happened, leaving much more gold-futures buying in the next few months. That's very bullish for gold!

Interestingly that 80.2k-contract average of post-spike short covering also fits in nicely with a couple of other key metrics. The first is the support line of speculators' total gold-futures shorts. Note above that after each earlier short-covering frenzy, speculators' total shorts bottomed at decreasing levels. Gold's $1200 support was effectively holding, so the wiser speculators started to give up on continuing to short it.

Today that support line is down around 60k contracts. The average 80.2k of covering would take total shorts down to the 70k range, getting in the region of support. Second, the last normal years before the Fed's gross market distortions starting in early 2013 were 2009 to 2012. During that secular span, the total gold-futures shorts held by American speculators averaged 65.4k contracts. Perfect for average covering!

So seeing this latest third-highest speculator gold-futures shorting spike on record yielding to average short covering of 80.2k contracts in 13 CoT weeks isn't a stretch at all. And that easily has the potential to drive an average short-covering gold rally of 14.1% over 9 weeks. Measuring from gold's recent mid-March low, a successful major retest of its deep early-November-2014 lows, this implies $1311 gold.

But that target is likely too conservative. In the past, speculator short-covering frenzies have pushed gold high enough to ignite new long-side buying by speculators and investors alike. If this next short-covering gold rally coincides with the lofty US stock markets and/or parabolic US dollar finally rolling over, there will be a big resurgence in gold investment demand way beyond speculator short covering.

Only time will tell exactly when the stock markets and US dollar inevitably reverse, but the current first-quarter earnings season is a risky time. Overall US corporate earnings are actually forecast to shrink year-over-year for the first time since soon after 2008's stock panic! That would make these already super-overvalued stock markets look even more expensive, likely triggering long-overdue major selling.

In that environment, a rare alternative investment like gold that moves contrary to the stock markets will be in high demand again. And speculators and investors alike today have forgotten just what gold looks like in normal times. This final chart zooms out to the past 7 years or so, showing how anomalously low the gold price has been and how anomalously high the speculators' gold-futures short positions remain.

With the Fed's gross financial-market distortions, there is nothing at all normal about 2013, 2014, or early 2015. With the Fed done with new QE3 bond buying and threatening to start winding down its zero-interest-rate policy this year, markets are finally going to start mean reverting back to normal. And for gold, that means much-higher price levels partially driven by speculators covering shorts and adding longs.

Despite all the extreme bearishness, gold has actually been extraordinarily resilient in recent years given the dire circumstances. Between its initial June 2013 low and its latest March 2015 one, gold merely slumped 4.2%. Yet over that same span, the flagship S&P 500 stock index and US Dollar Index blasted higher by 28.6% and 20.2% respectively! Enough latent investment demand still existed to stabilize gold.

That is going to explode when the stock markets and US dollar mean revert lower, portending far-higher gold prices in the coming years. The initial spark for this mighty mean-reversion upleg will likely be the American futures speculators covering their shorts. Buying begets buying, so the longer and higher gold rallies to convince investors its uptrend is sustainable, the more of them will return and amplify gold's gains.

Investors and speculators can certainly play this long-overdue normalization in gold price levels with the physical metal itself or gold ETFs like GLD. But those will merely pace gold's gains at best. Investors and speculators who want to leverage those gains should look to the left-for-dead gold stocks. No sector in all the stock markets is cheaper and more despised, and no sector has greater upside potential going forward.

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The bottom line is American futures speculators have dominated gold action in recent years thanks to the Fed's wild market distortions scaring away investors. In particular the gold price has a nearly-perfect strong inverse correlation with speculators' total gold-futures shorts. And in recent weeks, these just surged to what's very likely their third-highest spike peak in history. That's a very bullish omen for gold.

Big gold-futures short covering naturally follows extreme shorting, which catapults gold higher. Thanks to the incredible leverage inherent in gold futures, speculators betting against gold can't afford to be wrong for long. So they rush to buy to cover, a process which is already underway and feeds on itself. Gold easily has $1300+ potential in the coming months, and much higher if the stock markets roll over on weak Q1 earnings.


Apr 10, 2015
Adam Hamilton, CPA

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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