Gold-Futures Buying Returns

Adam Hamilton     November 8, 2013     3041 Words


Heavy and relentless selling by American futures speculators has been one of the primary drivers of gold’s horrendous year.  These traders abandoned gold on the long side while piling in on the short side, unleashing withering selling pressure.  But just in recent weeks, these speculators have started buying gold-futures contracts again on the long side.  This critical and long-awaited reversal is very bullish for gold.


Futures speculators have long been at odds with gold investors.  With gold futures’ inherent extreme leverage and expiration dates, speculators must maintain a very-short-term perspective in order to survive.  Their whole worldview is based on technicals and sentiment, with trades lasting hours, days, or maybe weeks on the outside.  Gold’s supply-and-demand fundamentals are largely irrelevant at this short scale.


Each futures contract controls 100 ounces of gold, worth $130,000 at $1300 gold.  Yet the initial margin speculators have to put up to trade in this market are merely $8,800 per contract.  This yields astounding maximum leverage of 14.8x!  This dwarfs the legal limit in the stock markets of 2x, which has been locked in place since 1974 by the Federal Reserve’s Regulation T.  Extreme leverage is a very unforgiving game.


After speculators open a gold-futures trade, the maintenance margin drops to just $8000 per contract.  At $1300 gold this enables maximum leverage of 16.3x.  At those extremes, a mere 6.2% gold move against a speculator’s bet will wipe out all of the capital he risked.  And in futures, losses can quickly snowball far larger than the money bet.  So futures speculators have no choice but to keep a very-short-term focus.


When gold plummeted in the first half of 2013, physical demand exploded worldwide.  Thanks to gold’s outstanding long-term fundamentals, investors were eager to take advantage of fire-sale prices to grow their positions.  But to futures speculators looking days ahead instead of years, gold’s free-falling technicals and hyper-bearish sentiment fueled an overpowering incentive to dump futures aggressively.


And with downside momentum in their favor, that’s exactly what these traders did.  They closed out many of their long-side contracts by selling them, stanching the leveraged bleeding.  And they multiplied downside bets by effectively borrowing gold to sell it short.  In futures markets, the price impact of selling to close long contracts and selling to open short contracts is identical.  This deluge of futures supply helped tank gold.


As 2013’s extraordinary and unprecedented gold-futures action unfolded, it was chronicled in a relatively obscure government report.  Once a week the Commodity Futures Trading Commission releases its Commitments of Traders report.  Known as the CoT, it details what commercial hedgers, large speculators, and small speculators are doing in the American futures markets.  Experienced traders watch it like hawks.


But rather interestingly, last month’s partial government shutdown effectively shuttered the CFTC.  It was deemed non-essential, which is certainly the case compared to jobs like air-traffic controllers.  So for the better part of October, the CoT report vanished as CFTC employees were first furloughed and then raced to get caught up when they returned to work.  They finally finished October’s CoT reports this week.


And something very bullish for gold happened during that data void, American futures speculators started to buy long-side gold contracts in major quantities again.  In fact, over the past couple CoT weeks (ending October 29th) futures speculators bought more long-side gold contracts than they had since back in late November 2012.  Back then gold was near $1750 and 2013’s crazy selling anomaly hadn’t happened!


This major gold-futures buying in recent weeks is a sea change, something we’ve not witnessed since the gold markets were behaving normally.  And I suspect it is the vanguard of much more gold-futures buying to come, which is super-bullish for the battered yellow metal.  This year’s extreme selling left speculators’ longs and shorts at such great extremes that it will take colossal buying to unwind them.


The massive mean-reversion buying remaining for American gold-futures speculators is revealed in this chart, which was built from the CFTC’s CoT data.  It shows both the total long (green) and short (red) contracts held by both large and small speculators, with gold superimposed on top (blue).  The long-side buying seen in recent weeks is truly just the tip of the iceberg as gold-futures positions return to normal.



While “normal” is a somewhat-subjective term, everyone would agree 2013 has proven an exceedingly atypical year for gold.  Gold experienced its worst quarter in something like a century in Q2, plummeting 23%!  A once-in-a-century event is obviously far from normal.  Another once-in-a-century selling anomaly happened in 2008, that epic stock panic.  Sandwiched between these extremes was some semblance of normalcy.


So it seems reasonable to use the four-year secular span between 2009 and 2012 as a baseline from which to compare American speculators’ gold-futures positions in 2013.  That was a long time frame that included both mighty gold uplegs and serious corrections, encompassing the spectrum of gold-market technicals and sentiment.  The average speculator positions in gold futures during this span are rendered above.


On average in this pre-2013 post-panic era, American futures speculators held the long side of 288.5k gold contracts and the short side of 65.4k.  To put these into terms gold investors can better understand, they equate to 28.9m and 6.5m ounces of gold respectively.  Or 897 and 203 metric tons long and short.  This compares to the World Gold Council’s 2013 annualized estimate of total global mine supply of 2765t.


Obviously these total positions changed with speculators’ collective sentiment.  Longs rose and shorts fell when they grew more bullish on gold, and the opposite when they waxed more bearish.  But all of this normal market activity, the usual flow and ebb of uplegs and corrections, is distilled into these baseline averages.  The sharp contrast between them and what we’ve seen this year really highlights 2013’s extremes.


Let’s start on the short side, with the red line in this chart.  In the past four years, futures speculators tended to have about 65.4k gold contracts sold short.  As you can see, the data underneath this average was pretty tight.  There were few large deviations from it, and total short positions soon mean reverted after they stretched too far away.  But all that changed dramatically in this year’s wildly-unprecedented gold selloff.


American futures speculators got so wrapped up in the short-term downside momentum and hyper-bearishness plaguing gold in 2013’s first half that their total shorts exploded.  They borrowed and sold so aggressively that by early July their total short position had rocketed to an astounding 178.9k contracts!  This was at least a dozen-year high, the most extreme speculator short position of gold’s entire secular bull.


I wrote extensively about that anomaly back in mid-July right when that peak CoT report was released.  I pointed out that epic outlying record couldn’t last, that speculators would soon be forced to unwind their shorts.  The only way a short futures contract can be closed is by buying an offsetting long one, and all that buying pressure would feed on itself.  Thus I concluded gold was due for an imminent short squeeze.


Like all contrarian thought, the heretical concept that market extremes always mean revert was ridiculed.  I was deluged by bears telling me how stupid I was for not seeing that gold would soon plunge below $1000.  Yet gold indeed soared as futures shorts were forced to cover, and by late August it had catapulted $218 higher (18%) from its brutal late-June lows!  Futures mean reversions are very powerful forces.


Since peak bearishness, speculators’ downside bets on gold have unwound dramatically.  The latest CoT available at this writing (October 29th’s) shows they’ve collapsed to 83.6k contracts.  So in less than 4 months, American futures speculators bought the equivalent of 9.5m ozs of gold in the futures markets!  But they’re not done.  To merely return to recent normal years’ average levels, another 1.8m ozs of buying remains.


But the gold-futures short squeeze is old news, the big development this week was the stunning reversal in speculators’ long bets on gold.  While we couldn’t know it at the time since the CFTC was closed for the government shutdown, in the week ending October 15th total speculator longs fell to just 175.7k contracts.  These were the lowest levels seen since December 2008, right after that once-in-a-lifetime stock panic!


Just like shorts being exceptionally high, longs being exceptionally low are a sign of peak bearishness.  Despite the recent flurry of short covering, speculators still overwhelmingly believed gold was due to keep spiraling lower.  Like always after a sharp plunge, commentary abounded trying to rationalize that selloff as being an ongoing trend rather than a major bottom.  Futures speculators as a herd always fall for this.


I’m not a futures trader and never will be, extreme leverage is far beyond my risk tolerance.  The reason I started studying what the futures speculators were doing many years ago is because they are such a fantastic contrarian indicator.  As a herd they always bet wrong at extremes, getting too bullish when gold is topping and too bearish when gold is bottoming.  So their futures positions extremes flag imminent major reversals.


In mid-October as longs dwindled, gold was slumping heading into the inevitable resolution of that temporary US government shutdown.  Traders nearly universally believed that when the great uncertainty of that event passed, gold would quickly be hammered to new lows under June’s.  Futures speculators sure bought into this excessive bearishness too, continuing to reduce their long-side gold contracts.


Falling to 175.7k a few weeks ago, they were a whopping 112.8k contracts below their 2009-to-2012 average levels!  That equates to 11.3m ozs of gold buying that would have to be done merely to mean revert to normal.  But after market extremes, the resulting mean reversions rarely stop at the averages.  Instead their momentum propels them to overshoot big in the opposite direction, which is very likely again.


Futures speculators hadn’t been so bearish since just after 2008’s stock panic, another time when prevailing consensus assumed gold was doomed since it hadn’t surged during that crisis.  Much like this year’s selloff, that was not a fundamental failing but a short-term anomaly driven by an extraordinary dollar rally.  This year’s anomaly is the result of the stock-market levitation spawning a GLD mass exodus.


All anomalies are inherently self-limiting.  Once practically everyone is already bearish, the vast majority of the selling has already passed.  That leaves only buyers so the battered price soon starts rallying.  In the years following futures speculators’ hyper-bearishness on gold after 2008’s stock panic, this metal would blast nearly 2.5x higher!  It wouldn’t surprise me one bit to see a similar gold surge in the coming years.


There’s one final line I want to highlight on the first chart before we move on.  The yellow one shows the total 2013 deviation in both speculators’ gold longs and shorts from their past four years’ averages.  This series reveals the total gold buying left from futures speculators alone in order to mean revert back to normal gold markets.  This next chart zooms in to the past year or so to offer a better view of this key metric.



The total speculator futures positions’ deviation from their 2009-to-2012 averages peaked along with shorts in early July at 204.1k contracts.  As these traders started to aggressively cover their shorts, their buying drove a fast gold rally as I predicted back in mid-July.  By the time gold hit its latest interim high in late August, speculators had bought 68.6k contracts.  This dropped the 2013 deviation back down to 135.5k.


But as you can see from the green total-longs line, nearly all that buying in July and August came on the short side.  Speculators had to cover their shorts as gold rose, since their extreme leverage put their capital at great risk.  Every gold contract they bought to close a short one pushed gold higher, which formed a self-feeding cycle motivating even more speculators to cover.  That was good for a $218 gold surge.


Today per the latest CoT this 2013 deviation is back down to 116.3k contracts.  Futures speculators still have to buy back the equivalent of 11.6m ozs of gold merely to mean revert to their 2009-to-2012 average levels of total longs and shorts with no overshooting.  This remainder is 1.7x larger than the big chunk of shorts the traders initially covered in July and August which catapulted gold sharply higher!  It is very bullish.


And futures speculators just started buying major new long-side gold contracts in the past few weeks.  All year long, speculators have been relentlessly abandoning longs.  But suddenly in the CoT week ending the 22nd, they bought 8.7k contracts.  They flooded back into gold after it didn’t collapse like the bears predicted after the US debt ceiling was extended.  This was the biggest surge by far since early February.


And early February is very interesting technically and sentimentally.  Back then gold was still trading near $1675, normal levels before any of 2013’s extreme selling broke out.  Gold remained far above its critical $1550 multi-year support then.  It was the failure of that level in April that spawned the extraordinarily anomalous futures forced liquidation that crushed gold down 13.8% in two trading days, killing sentiment.


Today’s entire gold worldview plagued by excessive bearishness is the product of the selling that started in mid-February as futures shorts tried to press their advantage, continued in April in that panic-like plunge, and climaxed in June after Ben Bernanke laid out the Fed’s optimal QE3-tapering timeline.  So to see futures speculators add new longs again like they last had before all that signals a major sentiment shift.


The CFTC finally got caught up with last week’s CoT late Wednesday afternoon, and that revealed futures speculators had purchased 14.7k net new long contracts over the past two weeks.  Again this was the best since late November 2012, when gold was trading near $1750 and no one could even have imagined what misery lay ahead in 2013.  Futures speculators are buying again like they were in normal times!


This sea change makes it look like the speculator longs finally bottomed in mid-October and are heading higher.  And with 116.3k contracts still left to buy to return to pre-2013 average levels of longs and shorts, this is very bullish for gold.  If gold rallies proportionally in the remainder of this mean reversion to what it did initially in July and August, it will soon power another $370 higher from today’s levels!  Imagine that.


At $1670, gold sentiment would be wildly different than it is today.  The extreme bearishness would be long gone, and there would be growing bullishness.  This would not only entice more futures speculators back in, but also accelerate the reversal of capital flows back into the flagship GLD gold ETF.  In the financial markets, buying begets buying.  The higher any price goes, the more people want to buy it.


The 11.6m ozs of futures-speculator mean-reversion buying remaining equals the equivalent of 362 metric tons of gold.  And since their all-time record high achieved less than a year ago in December 2012, GLD’s holdings have plummeted 487t due to 2013’s crazy-heavy differential selling pressure on its shares!  So as the coming futures buying drives gold prices higher, it has a potentially far greater upside price impact.


Even though they don’t like attempting to buy bottoms, it’s too risky, professional investors recognize that when a price has fallen far and fast a bottoming is likely.  So once a price starts rallying decisively and consistently out of those lows, they pile in to the trade.  Gold saw this in early 2009 after its brutal stock-panic lows.  Today’s young gold upleg driven by futures buying should again trigger big new capital inflows.


And if these extend to GLD as is highly likely, reversing the fund flows back into gold from the stock markets, watch out above.  If even half the capital that abandoned GLD returns in the coming year, gold is going to rocket higher.  Of course when the levitating stock markets inevitably roll over, alternative investments will return to favor for portfolio diversification and capital flows back into gold will surge.


But this whole process starts with futures buying.  Initially speculators cover their shorts, as we saw in July and August.  Then these short-term traders start adding new longs, as we are finally starting to see in a major way in the past couple weeks.  This futures buying ignites a large-enough upleg to start enticing other speculators and investors back in, and eventually all that buying feeds on itself and gold soars.


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The bottom line is futures speculators have finally started decisively buying again in recent weeks.  And this is not just short covering, but serious long-side buying.  They haven’t bought new gold futures in such large quantities since the gold markets were normal before 2013’s wildly-anomalous selloff.  This is a major sea change, the vanguard of the long-awaited mean reversion in futures to catapult gold higher.


While futures speculators are the first to buy after an extreme low, they pave the way for many other speculators and investors to follow.  First through short covering and then through new long-side buying, the futures speculators drive a price higher on balance to form a new uptrend.  As that uptrend persists and strengthens, other traders follow them in which soon forms a very bullish self-feeding virtuous circle.


Adam Hamilton, CPA     November 8, 2013     Subscribe