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Extreme Gold/Silver Shorting

Adam Hamilton
Jun 26, 2015

Gold and silver are languishing near major lows, trudging through the barren sentiment wasteland of the summer doldrums. The major factor behind this weakness is extreme shorting by American futures speculators. But their heavily-bearish bets are actually very bullish for both precious metals. Not only do these traders as a herd always bet wrong at price extremes, their shorts are guaranteed near-future buying.

American futures speculators' trading has utterly dominated gold and silver price action in recent years. This single group of traders doesn't normally wield such outsized influence. But with Western investors largely missing in action since early 2013, futures speculators have gone unchallenged. Couple this with the extreme leverage inherent in futures trading, and its stranglehold on gold and silver prices is ironclad.

This vexing anomaly started when the Federal Reserve's third quantitative-easing campaign spun up to full speed in early 2013. Unlike QE1 and QE2, QE3 was open-ended with no predetermined size or end date. The Fed deftly used this to its advantage, working overtime to convince traders that it would ramp up QE3 to arrest any material stock-market selloff. They came to believe the Fed was backstopping stock markets!

So traders were quick to buy every minor selloff, forcing the stock markets inexorably higher. Traders started to abandon everything else to chase these extraordinary Fed-levitated stock markets. They forgot about prudent portfolio diversification, and shunned alternative investments led by gold. So it suffered its biggest quarterly plunge in 93 years in Q2'13, as American stock traders jettisoned GLD gold-ETF shares.

That once-in-a-century hellstorm was so brutal that the vast majority of Western investors have yet to return to gold. They remain radically underinvested in this essential portfolio diversifier, one of very few assets that moves contrary to stock markets. And without normal investment demand, American futures speculators have had free reign to effectively hold precious-metals prices hostage to their bearish psychology.

This epic Fed-spawned anomaly has created a quandary for contrarian commentators like me. The small fraction of investors and speculators still interested in gold and silver these days want to hear about fundamentals like Chinese and Indian demand, traditional drivers. But in today's unprecedented environment, all that matters for price action beyond ETF capital flows is American futures speculators' trading.

When they buy gold and silver futures, the precious metals' prices rise. When they sell, gold and silver fall. The correlation between recent years' price action and American futures speculators' holdings is incredibly high. While I can't wait for this anomalous dominance to fade again as investment demand finally normalizes, today it remains the overwhelmingly-controlling driver of gold and silver price action.

This is crystal-clear when charted. American speculators' total positions in long and short gold-futures contracts are published once a week by the US government's Commodity Futures Trading Commission in its famous Commitments of Traders reports. And when gold and silver prices are superimposed on this futures-holdings data, the results are striking. All contrarians have to understand this stranglehold on prices.

This chart may look complex, but it's quite simple. Humorously, a Polish university professor in South Korea has been trying to get a previous iteration of this chart accepted by Wikipedia as its "busy graph" example! All it shows is the daily gold price in blue overlaid on the weekly CoT futures-positions data. American speculators' total long positions in gold futures are shown in green, and their total shorts in red.

Finally the yellow series shows the total deviation of these holdings from their average levels between 2009 to 2012. Those were the last normal years before the Fed's wildly-unprecedented QE3 campaign radically distorted the global markets. But our focus today is on the strong inverse correlation between the gold price and American speculators' gold-futures short positions. They have become gold's entire story.

Whenever this single dominant group of traders has significantly ramped their leveraged downside bets on gold, this metal's price has fallen. And then as soon as these guys hit selling exhaustion and their shorting peaks, gold bottoms. The light-red vertical bars above mark major peaks in speculators' gold-futures short selling, and they closely match gold's major bottoms. The only reason it's not exact is data resolution.

American speculators are actively trading gold futures every day the markets are open, yet the CoT only reports their positions once a week. But near major reversals in gold's fortunes, futures trading becomes fast and furious within CoT weeks. So the apparent precision of gold-futures shorting in driving gold's price action of recent years is obscured. In this information age, the CFTC really ought to release daily CoT reports.

The extreme shorting of recent years began in early 2013 as the Fed ramped QE3 to full steam. While that particular once-in-a-century gold plummet in Q2'13 was also driven by extreme gold-ETF selling by American stock traders, futures shorting played a majority role. That quarter's GLD liquidations soared to an epic record 251.8 metric tons of gold! But even that colossal sum was actually exceeded by futures dumping.

In that same quarterly deluge of torrential gold selling, American speculators liquidated 58.8k gold-futures long contracts while adding 76.9k short contracts. Since each contract controls 100 troy ounces of gold, this equates to 183.0t and 239.1t respectively. So the 422.1t of gold supply spewed into the markets by futures speculators in that climactic gold-selling quarter dwarfed the monster selling pouring in via GLD!

By the time the dust settled in mid-2013, American speculators had ballooned their total gold-futures shorts to an astounding 178.9k contracts! That was the highest level witnessed since at least 1999, the extent of our historical CoT data. And it was very likely an all-time record. Gold bottomed right as these traders' bearish downside bets in this metal peaked. And then a massive short-covering rally ensued.

Shorting anything in the futures markets is extraordinarily risky due to their inherent extreme leverage. In the stock markets, leverage has been legally limited to 2 to 1 since 1974. The Fed instituted that 50% margin rule in response to a near-panic in the US stock markets, and it's never been changed. But in the futures world, normal limits don't apply. These speculators can run leverage that is quite frankly crazy.

This week with gold trading near $1175, the minimum maintenance margin required to hold a single gold-futures contract is just $3750. But each contract controls 100 ounces of gold worth $117,500. That means futures speculators can run leverage up to an absurd 31.3x! 31 to 1 is enormous beyond belief, giving the capital these traders risk a radically-disproportionate and totally unfair impact on the gold price.

Every single dollar bet on gold futures by American speculators has the same impact as up to $31 in the underlying physical gold market or up to $15 in the gold ETFs! So it's no wonder futures trading has utterly dominated gold in recent years, especially with Western investors largely abandoning alternative investments. But such extreme leverage leaves little margin for error, as losses can mount at dizzying speeds.

When the gold price moves against a fully-leveraged futures speculator's bet, their entire capital risked can literally be wiped out within days. At 31.3x, a mere 3.2% adverse move in gold would devour 100% of the money bet on that contract. And a total loss isn't even the worst of it. If traders can't exit their trades quick enough, they are subject to margin calls requiring them to immediately deploy even more capital.

So once short covering gets underway, this process quickly feeds on itself and accelerates. In futures markets, the only way to close a short contract is to buy a long contract to offset it. And the upside price impact of buying longs to close shorts or buying new longs is identical. So the more speculators who rush to cover their shorts, the faster gold's price rallies. The quicker it surges, the more it forces others to cover too.

Thus American futures speculators' short covering fuels sharp rallies in gold. After growing their shorts to record highs in mid-2013, this perpetually-wrong-at-price-extremes group of traders covered 95.3k contracts in 16 weeks. That was the equivalent of 296.4t of buying, and it catapulted the gold price 18.2% higher in less than 9 weeks leading into the autumn of 2013. Extreme gold-futures shorts are very bullish!

But with investors still missing in action in late 2013 as the US stock markets continued levitating, American futures speculators couldn't resist returning to their bearish ways. They effectively borrowed and sold gold futures aggressively, catapulting their total downside bets back up to 150.0k contracts. That turned out to be a super-important level, defining major overhead resistance for gold-futures shorts.

But selling exhaustion was reached even as gold plumbed new lows below mid-2013's. And once the futures speculators are done selling gold, it quickly surges higher since that fierce supply headwind vanishes. So they bought to cover 72.3k contracts over 15 weeks leading into early 2014, which helped propel gold 16.2% higher in about 11 weeks. Are you starting to see the pattern here? It's very relevant today.

Covering short positions is not optional for futures speculators. They borrowed gold futures that they did not own, sold them, and are legally obligated to soon repurchase these gold futures to repay these debts. So extreme gold-futures shorts held by speculators is guaranteed near-future buying for the gold market. Self-feeding short covering all alone is actually all that's necessary to rapidly catapult gold higher.

This trend continued last year, with this group of traders waxing super-bearish and ramping their shorts. But they soon hit selling exhaustion, reaching their limits for making hyper-risky downside bets against a deeply-out-of-favor asset that refuses to tumble significantly lower. So they soon rush to cover and the resulting gold-futures buying rapidly pushes the metal higher again. These sentiment-driven cycles are common.

Even in this grossly-distorted QE3 era thanks to this uber-dovish inflationist Fed, speculators' total gold-futures shorts have carved a very-definite trading range. Their zeal for shorting gold futures dwindles whenever their total short contracts near 150k, regardless of gold's price level. And then they soon scramble to cover, buying enough long contracts to push shorts back down near their 75k lower support level.

Provocatively in the latest CoT week's data available before this essay was published, speculators' total gold-futures shorts ballooned to 148.3k contracts. That is right at the 150k resistance that has proven so bullish in recent years! This implies major short covering is coming soon. And once this process gets started, it rarely stops until these traders' total short holdings are driven back down to their 75k support.

That will require an incredible 73.3k contracts of short covering alone, the equivalent of 228.1t of gold buying! And a range of catalysts could spark it anytime. With gold's seasonals bottoming right now, we are on the verge of this metal's major seasonal rallies driven by various demand surges in late summer, autumn, and winter. Seasonal tendencies shifting from very weak to very strong alone could spark short covering.

Plenty of other potential gold-buying catalysts exist too. The lofty Fed-inflated US stock markets are on the verge of rolling over decisively as the threat of imminent rate hikes looms. The euphoric US dollar that has kept a lid on gold investment demand is weakening. The Greece nightmare could hammer the European stock markets anytime, and the popular speculative mania in the Chinese stock markets is failing.

Regardless of the triggering catalyst, with speculators' gold-futures shorts so extreme today serious short covering is imminent. And that is going to propel gold dramatically higher. In the 3 prior times these traders' total gold-futures shorts challenged or exceeded 150k contracts in recent years, gold powered higher an average of 16.2% in just 10 weeks! And that was even with the stock markets still levitating.

Apply this merely-average gold-short-covering rally to this metal's price as of its latest CoT report, and we would be looking at $1375 gold by its next major seasonal peak in early October! And that is so much higher than today's dismal levels that it will probably even motivate Western investors to start returning. I suspect that process has already begun, as gold-futures shorting is losing its efficacy in battering gold lower.

Despite speculators' downside gold-futures bets nearing 150k resistance twice this year, extreme levels by any measure, gold has not fallen significantly this quarter. When taking on such hyper-dangerous leverage, speculators need to quickly see profits on their trades. Their increasing inability to force gold lower is going to make them nervous, as they have to start wondering if super-cheap gold warrants selling low.

And contrary to the totally-false popular belief today, the Fed's coming rate hikes are no threat for gold. Yes gold yields nothing, but rising-rate environments are very damaging to stocks and bonds. So when the Fed hikes rates, investors tend to flock back to alternative investments led by gold. Since this hard historical truth is absolutely essential for contrarians to understand, I've written important essays exploring it.

During the Fed's last rate-hike cycle from June 2004 to June 2006, it more than quintupled its Federal Funds Rate to 5.25%. Yet over the exact span of those rate hikes, gold blasted 50% higher! A similar gain from this week's levels would catapult gold well over $1750. And that's not farfetched. In all of 2012 before the Fed's gross QE3 distortions began, gold averaged about $1675. It will certainly mean revert back up.

And the last time the Fed was forced to seriously hike rates to atone for excessive easing was in the 1970s. It raised its FFR from 3.5% in early 1971 to an astounding 20.0% by early 1980! Yet gold didn't collapse as yields soared as naive analysts argue today, it skyrocketed an epic 24.3x higher on surging Western investment demand! Rate hikes are very bullish for gold since they are so damaging to lofty stock markets.

Provocatively the situation in American speculators' downside bets on silver is even more extreme than gold's! While silver is driven by gold, it too is on the verge of a major frenzy of short covering. This next chart reveals the same CoT data for silver, and it is dazzlingly bullish. So when the inevitable next gold-futures short-covering spree gets underway, this same fast-buying phenomenon will also ignite in silver.

According to the latest CoT data, American speculators' silver-futures shorts have soared way back up to 66.4k contracts. That is nosebleed high, not far below their all-time record peak of 70.0k contracts back in early November 2014. Incredibly in the last two CoT weeks alone, this group of traders grew so bearish that they ramped their silver-futures shorts by a breathtaking 132% or 37.7k contracts! Talk about extreme selling.

Yet silver barely budged, which is a big warning sign to these futures speculators that their leveraged downside bets are far riskier than they thought. In order to return their current extreme shorts back down to support near 27k contracts, they are going to have to buy to cover around 39.4k contracts. Since each contract controls 5000 troy ounces of silver, that is the equivalent of a staggering 196.8m ounces of buying!

So once gold starts moving decisively higher on short covering, the speculators heavily short silver will be forced to cover too. Since the extreme shorting in both precious metals represents legally-mandated guaranteed near-future buying, the coming months ought to see major rallies in this deeply-out-of-favor sector. Contrarian traders smart, courageous, and foresighted enough to buy ahead of the crowd will reap big gains.

The coming short-covering-fueled gold and silver rallies can be played in the metals themselves or their leading ETFs. These are of course the GLD SPDR Gold Shares and the SLV iShares Silver Trust. But these precious-metals gains should be really amplified by the left-for-dead stocks of their best miners and explorers. No other sector in all the stock markets has greater potential for monster gains in the coming years!

At Zeal we're veteran contrarians specializing in this realm, and we have been aggressively adding trades in outstanding gold and silver stocks in recent months. These companies are doing fine despite the super-low metals prices, and will see their profits and stock prices soar as gold and silver inevitably mean revert much higher. Now is the time to get deployed, not later after the coming gains have largely been won.

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The bottom line is American speculators' short selling in gold and silver futures has reached extremes in recent weeks. This single group of traders commands a wildly-disproportionate impact on prices due to the absence of investors and outsized leverage inherent in futures trading. But extreme shorting is a very bullish indicator, as offsetting long futures contracts must soon be bought to cover these excessive shorts.

Even in the recent years grossly distorted by the Fed, major short-covering rallies have erupted in the precious metals from speculators' same extreme short levels as today's. Taking up to several months to unfold, these short-covering frenzies lead to double-digit-percentage gains in gold and silver prices. And there's a great chance these coming rallies will grow much bigger as the stock markets start rolling over.


Jun 26, 2015
Adam Hamilton, CPA

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