Gold-Futures Short Covering

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by Adam Hamilton, via Zeal, The Daily

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.

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