April 16, 2005
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
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.
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
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
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
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
All speculators start small, and it is only the successful ones
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
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
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 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
Thoughts, comments, or flames? Fire away at firstname.lastname@example.org. 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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