Gold Commitment of Traders Explains surge in Open Interest

Many commentators have been confused by the recent open interest readings that we have been getting out of the CME Group detailing the movements of traders into or out of the gold futures markets. They have been looking at the huge increase and have been somewhat baffled at best and downright confused at worst.

While there is no doubt in my mind that it was a series of extremely large sell orders that got this downside ball rolling something else is going on that explains these open interest readings.

The usual pattern that we have seen in the gold market over the last decade-plus bull market has been a build up in the hedge fund long positions as they buy the market which is countered by the bullion banks and swap dealers taking the other side of that trade and going short. At some point, the market stalls in its upward momentum, a trigger occurs, and then the price reverses as the hedgies sell out or liquidate their long positions. This selling is then met with buying or the covering of shorts by the bullion banks and swap dealers.

At some point, the buying in the physical market becomes so large that it prevents any further downside price movement whereupon the market then stabilizes and the process repeats itself with price going on to make yet another high.

During these periods, many expect to see open interest shrinking as the price descends because it shows that many participants are reducing their positions - the hedge funds are getting out by selling previously established longs and the bullion banks and swap dealers are getting out by buying previously established shorts.

When open interest readings increase, it tends to confuse some as it seems to contradict the usual pattern that has become so familiar. What is leading to confusion is that the SPREAD POSITIONS of some of the LARGEST TRADERS are not taken into account.

I have graphed two of these categories for you to see and noted the price action in gold that occurred over this same period. The two categories are the SWAP DEALERS and the OTHER LARGE REPORTABLES.

This latter category includes the likes of CTA's (Commodity Trading Advisors), CPO's (Commodity Pool Operators), Large Locals from off the Pit Floor and other Large Private Traders. While these groups do not have quite the same impact as the enormous Hedge Funds, they are still large enough to affect trading.

Can you see the big spike higher in their spread positions back in August 2011, when gold shot up to $1924 and then collapsed all the way to $1535 before it stabilized? Now look at this past week's spike higher. See a pattern here? By the way, the sharp increase in the number of spreads put on by the Large Reportables Camp ( 87,178) was the largest single week increase for that camp on record. The increase in the Swap Dealers' Spread position (+49,768) was also a weekly record.

There is your REASON for the SURGE IN OPEN INTEREST.

There is a strategy behind this which I will not get into right now in detail due to time constraints ( soon coming attraction) but suffice it to say for now that it is an attempt first to get downside protection and cushion losses for those who are long and are on the wrong side. Second - the proper use of a spread position can be very advantageous to traders who can time the markets accurately enough to leg into and leg out off these spreads. It requires considerable skill however to pull this off and trading accounts large enough in size to allow for the jump in margin requirements as one leg of the spread is lifted.

IF we leave off the impact of these spreads in the overall open interest numbers, it would have only seen an INCREASE of +14,460 compared to the previous week. This was based on the bullion banks increase of both their long and short positions (which incidentally favored more longs at this point than shorts) and an increase in the SHORT positions of the small specs, the general public who sold down into what might turn out to be a hole. When we take into account the sharp increase in the number of spreads, we see a completely different picture with open interest increasing over 154,000 contracts this week alone.

Therein lies the "mystery" for the open interest readings for the past week. If gold stabilizes here and begins to base build, watch for these spreads to be drawn down.

Trader Dan Interviewed on King World News Markets and Metals Wrap

Please click on the following link to listen in to my regular weekly radio interview with Eric King over at the KWN Metals Wrap.

http://www.kingworldnews.com/kingworldnews/Broadcast/Entries/2013/4/20_KWN_Weekly_Metals_Wrap.html

Monthly Gold Chart

I wanted to see how this week's price action in gold would resolve itself so that I could do a bit of analysis on the market. Keep in mind that this is LONG TERM stuff. The nature of markets nowadays being what it is (they are run by hedge fund algorithms which do not think but just issue buy or sell orders automatically once certain trips are triggered) it helps to get a sense of where we are in the general scheme of things by looking at the larger picture to see if we can identify a long term trend.

I realize that the chart is cluttered but it needs to be in order to show the areas I have pinpointed that need some attention given to them. I have laid out TWO separate Fibonacci retracement patterns starting with the 2001 low and extending to the 2011 peak PLUS one starting with the 2008 low and running to that same 2011 peak up above $1900.

Then I have drawn in TWO separate pitchforks - one for use during the bullish phase and one for use during this now bearish phase.

I am interested in seeing the intersections between these various levels that are generated. Look at the area I have noted with an ellipse. It contains TWO Fibonacci retracement levels - the 38.2% retracement of the entire rally beginning in 2001 and the critical 50% retracement rally from the 2008-2011 rally. Can you see how those center around the $1300 level?

Now note the two pitchforks - the one uptrending, and the other downtrending and locate the intersection of the median or middle lines in both forks. Can you see how it come in right on top of the previously mentioned TWO Fibonacci retracement levels?

What does all this entrail reading denote? Simple - the area near and around the $1300 level is now critical for gold's fortunes as we move forward.  I believe it has as much significance as the former support zone back up near the $1525 region.

If this region fails for any reason, gold is going to fall first to $1200 and then possibly $1100 - $1092.  That would dovetail with the BEARISH FLAG FORMATION I have noted on a previously posted daily gold chart that would target another $200 drop if this week's low were to be violated on HEAVY VOLUME.

If the bulls can hold this market above this week's low but certainly above the $1300 level, then they stand a real chance of forcing a period of price consolidation or sideways movement. I believe it is too much to expect this market to ricochet sharply higher after the psychological beating that the bulls have received this past week.

While it is certainly encouraging to see the strong physical offtake that these lower prices are stimulating, it will require the return of the hedge funds to the long side of this market to take it sharply higher. for that to transpire, we must see fears of inflation displacing fears of deflation or slowing growth. Falling interest rates globally are showing that currently there exists no fear of inflation from Central Bank money creation at this point.

This week's Commitment of Traders report might be misleading to some because it shows Hedge Fund short covering occurring. Some might be tempted to think that they are abandoning the short side of the market. What needs to be understood is that gold plummeted over $200 in the matter of a couple of days. When it hit $1320, some shorts prudently booked some profits. The market then popped $40 off of that level. The next day, Tuesday, it fell back down to that $1320 level, but rebounded all the way back up towards $1400. That buying was SHORT COVERING on the part of the hedge funds. Once it showed that it was not going to break support, they rang the cash register on some short positions. They are however looking to sell rallies so they probably re-entered above $1400 during today's session (Friday).

We saw similar data in the COT for both silver and copper. Both of these metals showed that same short covering by the hedgies. In copper they covered some of their shorts below the $3.25 level on Monday and Tuesday. In silver, they covered some of their shorts on the steep fall towards $22. The trends in these metals are lower however and that means rallies will be sold by the speculative crowd dominated by the hedge funds.

To force some of these guys out of their short positions, it is going to take a concerted effort by the bulls to push price high enough to trigger their algorithms into buying. I am not sure where that catalyst might come from in the very near future. For starters I would need to see some sort of upside reversals in various commodity futures markets, notably copper and crude oil/gasoline and then the grains. In other words, the CCI would need to forge a bottom and show a definite upward turn with a trend change.

Fundamentally, we need to see a rise in real wages as well. Interest rates also would need to show a shift in the curve towards anticipation of inflation by the bond markets. They will pick it up long before the herd that looks only at equities figures it out.

Gold sees Strong Short Covering in Asia

Last evening here in the US, while watching the gold price action, it was evident that the reports of strong physical buying spooked a fair number of weak-handed shorts. In watching the price climb, once gold poked its head above $1400, but especially $1402 or so, the stops got hit and up she went. Volume picked up as the stops were continuing to fire, until the market ran out of steam up near $1425 where it began to retreat.

That was the high point for the session. Once trading moved into New York and the PM Fix was over, with India and the rest of Asia now closed, bears were able to take the metal down below $1400 again before the pit session closed. However, in the after market it has been floating back above $1400 once again.

I would have liked to see this thing hold onto a handle of "14" but at least it closed firm even though it was down some $106 for the week.

We have some technical chart points now to work with on this market. Support is in the zone noted extending down from $1365 and below while resistance is last evening's high near $1425.

A couple of things can be said about this chart. First, the more ominous news - the chart is displaying a near picture perfect BEARISH FLAG FORMATION. (That formation is shown in BLUE). If this market were to somehow break support on the downside after showing a pattern like this, it would portend the possibility of another $200 drop before all is said and done. I shudder to think what that would portend however for the global economy because it would signal that the Central Banks and their money spigots have failed completely in the battle against deflation. If that were the case, the stock markets globally would implode.

Having said that, based on the type of solid demand mentioned this past week, I find it very hard to believe that this week's support zone will not hold. Again, if it does not, we are all in for a world of serious hurt.

The positive news from the chart is that the market has gone down to this support zone THREE TIMES this week and on each and every visit down there, it has encountered more buying than selling! Bears surely want to break it lower but they could not.

The other thing is that the HUI showed some signs of life this week after getting the snot beat out of it nearly nonstop over the last two week period. If this index can manage to somehow claw its way back above the 300 level, I would feel much more confident saying a long term bottom is in on that chart. That remains a good ways above the current level however with its close just shy of 270 this week.

Again, I strongly believe that since the mining stocks led this market lower on the way down, they should be the first to turn if this market is going to head back up. Why? Because it will signify the RETURN OF INVESTMENT MONEY into this gold market.

Russell 2000 Bounces but Remains Weak

The Russell 2000, an index of smaller cap stocks, has been a pretty decent indicator of investors' sentiment towards the risk trade or the "improving global economy" trade.

It tended to outperform the broader market as stocks went on a maddening tear higher with the unleashing of the Fed's QE programs. Those combined with the ECB bond buying program in the Euro zone and now, the conjunction of the Bank of Japan's bond buying policy, had gotten investors in a tizzy to chase stocks higher no matter what the economic news was.

In a case of "Heads - I win" or "Tails - You lose" if the economic news was improving, stocks went higher on talk about the improving economy. If the economic news was bad, stocks went higher anyway because equity perma bulls could point to the lousy data as evidence that the QE programs would continue. Regardless, it was "BUY, BUY, and BUY"; no questions asked.

Suddenly, the bottom began to drop out of various commodity markets, most notably copper and of course gold and silver. But even crude oil and gasoline had been breaking down on their charts to the extent that the entire CCI, Continuous Commodity Complex has been swooning. There does come a point where even the most die hard stock bull has to start wondering how long his or her market can continue to levitate in the face of one piece of evidence after another that all is not well in La-La Land.

While we are seeing another miraculous recovery in stocks today, even as copper sinks further into bear market territory, that rally cannot hide the deterioration that is now solidly entrenched on the technical price charts.

Take a look at this Russell 2000 daily chart. It had fallen below the very important 50 day moving average early this month but managed to recover and rally back to near the recent high. Instead of attracting buying however, it began to attract selling. The result was a technical failure that has sent this index lower. This week, on Monday, the index broke firmly below the 50 day moving average again. After a feeble attempt at moving higher, it swooned on Wednesday and continued lower Thursday. Here, we are seeing what we have come to expect at this point on a Friday - the equity markets are miraculously saved from even more severe chart breakdowns just in the nick of time (PPT anyone?).

That being said, the index has now been trading below the 50 day moving average the entire week. The longer it stays below that average, the more likely it is going to break down further. I have noted two additional important moving averages, the 100 day and the 200 day. Notice that the horizontal support line I have shown in dotted red, come in exactly at the 100 day. That seems a logical target for this market at this point.

If this index falls below that level and cannot get back over it within the same week, I believe we are going to see a much more severe downdraft in the equity markets commence. What this will be telling us is that a growing number of stock investors will be turning bearish on equities even in the face of all this QE stimulus coming from both the Fed and the Bank of Japan. In other words, the investor world will be sending a signal that it no longer believes the bond buying programs are going to have any efficacy on creating any kind of serious growth!

Also note something that we have not seen in quite a while (early November of last year - remember when the "fiscal cliff" thing was all the rage), namely, the 50 day moving average is now turning lower. That bears watching.

Something else I have noted in my personal studies but will not post here is that the Homebuilders ETF, XHB, shows a chart pattern that is almost identical to this one. The same things that were said about the Russell 2000 apply to the XHB, it has been a strong performer to the upside as the housing sector has been seeing some signs of activity based on the availability of cheap mortgage money. If the housing market does roll over, this economy is in serious, and I mean serious trouble. I personally believe that this is what Dr. Copper has been forecasting.

This is the reason that I feel silver is having trouble even as gold has been showing good resiliency down here. The selling in copper is simply too much for the silver market (paper) right now as investors are selling base and industrial metals as they bet on slowing growth.

Today's Commitment of Traders report for copper shows the hedge funds still net short by a 2:1 margin. The report picked up the short covering among these big traders down below 3.25 on Monday and Tuesday but it did not catch the ferocious selling that hit this market the remainder of this week. My guess is that they went right back onto the short side in larger quantities again.

CME to Launch New Mini Silver Contract in June

The CME Group announced today that they will be launching a new 1,000 ounce silver contract in June of this year. The September 2013 contract will be the launch contract.

As some of you may know, a full sized silver contract at the CME is 5,000 ounces.

The CME appears to be after some more smaller spec business. The interesting thing about this contract is that is will be fully fungible. That is a big deal if you ask me. If you accumulate FIVE of these smaller contracts, you can exchange them for one full sized contract.

I am going to be extremely interested to see how the volume and interest does in this contract. It might be a way that some of those who are interested in playing the silver paper game can get involved. Oftentimes, the extent of the price swings in silver and the relatively high margin rates can put the benchmark contract out of the reach of many smaller players.

I have not had time yet to see if a single contract will be able to be held into delivery. My guess is that it will require FIVE as I am unsure whether there are any 1,000 ounce bars at the warehouses that could be used to satisfy the delivery requirements any way.

Keep in mind, this is for trader primarily, not those who are only interested in the actual metal. One neat thing about this new size is that it might enable some smaller holders of the metal to hedge their holdings if they are expecting a period of price weakness....

Random Thoughts

Reports coming in from nearly all corners of the planet, but especially from Asia, continue to reveal massive buying of physical gold. Last evening, what was obviously a huge bear raid that occurred during the early Asian session, was repulsed by very large buying above the recent low.

That is very interesting and has my attention. In a sense, we seemed to have gotten our second test of the low, a test in which that low held once again. With the wild price swings being made in this market, it is hard to be too dogmatic, but the way this market is acting, based on the news of strong physical offtake down near the $1350 level, I am greatly tempted to say that a low is in.

Here is what I am currently seeing here. We certainly have the strong demand for physical - the big question I have is whether or not this is sufficient to take the market higher WITHOUT the strong investment demand from the hedge fund crowd that we have seen for so many years. Remember, that crowd is selling right now in the paper markets.

What spooked a lot of the gold analysts were those speculative outflows from the gold ETF, GLD. There was also large scale buying of put options there as well. As a side note, I asked then and continue to ask now, who has been buying all that gold that was being sold out of the GLD?

So once again we are back to witnessing the same battle that we have seen for over a decade now - the clash between the physical gold market buyers and the selling of the paper markets by the hedge funds.

How this might translate to price action is a market that stops moving lower but also one in which it cannot scoot higher either. There is an uneasy truce between bull and bear. Bears cannot break it down any further based on the amount of physical offtake but bulls need more recruits to their side from the hedge funds to have any upside fireworks occur. Thus we move in a broad range between the recent bottom and $1400 on the top.

Obviously, for gold to now recapture any bullish excitement, the handle of "13"needs to be replaced by the handle of "14" at a bare minimum. If that occurs, we will see some short covering begin among those who have sold down below $1350. They are counting on fresh selling into rallies to support their side of the argument and if they suspect that their allies might be wavering, fear of larger losses will send some of the packing.

It will all eventually come down to CONFIDENCE. When enough people around the globe, begin to lose confidence in their own currencies (and bond markets) and the policy of their respective Central Banks, the gig will be up. The large physical buying of gold is evidence enough that a growing number of people are increasingly concerned about the health of their domestic currencies.

When will the paper markets begin to reflect that again? The answer is unclear; but I am convinced it will happen. Keep in mind that the current monetary system as we know it, and I am talking about Bretton Woods, is not even a century old. As flawed as that was, at least there was some place for gold in that system. Since 1971 however, the entire system has been supported by nothing other than CONFIDENCE.

In effect, we are a little over a generation (40 Years) in an EXPERIMENT by Central Banks with a monetary system held together by nothing but sentiment! Think about that for a moment and let it sink in. This is why I believe these monetary masters are pulling out all the stops to somehow keep the public from any sort of nervousness, concern or panic. Yet, in spite of all that, we keep getting hot spots that continue to flare up.

This brings me back to the paper markets -

 In the SHORT term the paper market can be used to push prices all over the place, sometimes disconnected from reality, because of the vast sums of money that are involved due to the proliferation of hedge funds who borrow gazillions of the stuff for next to nothing and then stuff it into various markets around the globe.

 

This gargantuan sum of hot money, every bit of which has been given to us by the Federal Reserve and the Bank of Japan, is a rolling juggernaut that crushes whatever is on the other side of it. Whether it is exiting a market or entering a market, its appearance produces all manner of price distortions, both on the way up and on the way down.

 

Eventually, the fundamentals reassert themselves however. They have to or the paper market ceases to be of any value in the real world whatsoever. Remember, there are thousands of commercial entities that must rely on that paper market to hedge both long and short positions as part of their overall risk management programs. Wild swings in price, disconnected from reality, destroy hedges put in place by commercial entities because MARGIN requirements, though lower for bona fide hedgers, still must be met EVERY SINGLE DAY at the settlement process.

 

A hedge position can thus be blown to pieces by this sloshing wave of speculator  activity requiring large margin calls and causing financial duress for a commercial hedger. This defeats the very purpose for which they employ the futures markets in the first place, THE MITIGATION OF RISK. The last thing any entity engaged in the use, production, selling, purchasing, etc., of any commodity wants is to stay up nights losing sleep over fears of an obliterated hedge position.

 

If the paper markets become so volatile and so disorderly, eventually these commercials will begin to look for other mechanisms to offset risk other than the futures markets.  This will reduce the size and scope of the commercial participants in these markets leaving them more and more to the speculators. The problem with that is that this crowd, thanks to the algorithms, tends to move to the same side of the market, meaning that there will be fewer and fewer large traders to take the other side of their trades. Can you even remotely imagine what that will do to market volatility and to the eye-popping, stomach wrenching price swings??? It will for all practical purposes, render many of these markets untradeable.

 

I will go on record here and now stating the NUMBER ONE SOURCE OF MARKET INSTABILITY is the zero interest rate policies of the Western Central Banks, (and the Bank of Japan). It is these institutions which have created this gigantic pool of hot money and who continue to increase it month after month all the while producing a near zero interest rate environment in which it is impossible to obtain a decent rate of return on investment capital for most people. This tsunami of hot money crashing ashore and then receding back only to crash ashore again and recede back out again, repeat ad nauseaum, ad infinitum, is what has given rise to the insanity that we now daily witness in the paper markets.

 

Rather than having a calming or stabilizing influence on the markets, the “masterminds” behind it have re-defined the world volatility. This wall of money is so fickle, so unwed to any deep-seated conviction, that it is a beast, a truly out-of-control behemoth that can easily devour the entire financial global system.

 

Just watch the extent of the price moves in various markets and tell me that this is "normal" behavior. Those of us who have been doing this for a long time can tell you that we can recall periods of extreme volatility but those periods were more or less exceptions from the norm. They tended to be of rather short duration and burned out quickly. What we have nowadays is apparently now the NORM and periods of relative quiet are the exception!

 

The Central Banks, in an attempt to prop up their rotten Dagon, are fighting furiously again the results of excessive debt by vainly trying to encourage more of it! They are attempting to counter the forces of deflation by employing what they can to foster the forces of inflation. This is the war that is raging in the financial markets and is why this volatility will be with us until one side or the other vanquishes its opponent.

 

Thank you Mr. Central Banker. Job well done. Keep telling yourselves how successfully your policies are working.

Global Interest Rates Plunging

Further evidence that the reflation schemes of the Western Central Bank are apparently failing can be seen in the collapsing yield across the global bond markets.

News out of Europe this morning that March Auto Sales fell to a TWENTY YEAR LOW has shaken the confidence of investors in the demi-gods manning the turrets of the Central Bank towers. It seems as if even the mighty German economy, which has heretofore been the stalwart among the European economies is not immune from weakness.

Dow Jones is reporting that the Swedish Central Bank just cut that nation's growth outlook for 2014. The Bank of Canada lowered its forecast for this year. Remember, it was just yesterday that we received the projections from the IMF detailing their prognosis for global growth by revising it lower as well.

The result - a mass exodus out of stocks (for the time being) and back into the "safety" of sovereign debt. Investors figure that the Central Banks will be there to mop up any excess supply of bonds in effect watching their backs for them.

Need some evidence? Look at the chart below. The yield on the Ten Year Treasury note has hit a FOUR MONTH LOW in today's session. It was over 2% a little over a month ago and is now down below 1.7%.

This is what has Fed governor Bullard so concerned. These guys can read what is happening. It is also why copper and crude oil, two key economic barometers continue to plunge.

What will the Central Banks do if they current bond buying programs still cannot generate enough consumers/businesses to borrow and spend????

By the way,  I laid out the data in this format because this type of chart tends to cut through the "noise" and give a cleaner view of the larger trend.