The Mass Exodus From The Gold market
Adam Hamilton | Jul 29, 2012 03:27AM ET
Gold has been deeply out of favor lately, languishing in its usual summer doldrums. This sentiment wasteland is driving traders to flee wholesale, including the futures players. Their mass exodus from the gold market is readily apparent in futures data. But provocatively such behavior is a powerful contrarian indicator, heralding the birth of major new uplegs in gold. Bearish futures traders are a bullish omen.
This truth is easily demonstrated through the granddaddy of all futures reports, the Commodity Futures Trading Commission’s Commitments of Traders. The giant CoT is released every Friday afternoon, with data current to the preceding Tuesday. It details the futures positions currently held by several classes of traders in nearly all US futures markets. When analyzed over time, these yield many trading insights.
The most basic piece of data the CoT reports is open interest, or the total number of futures contracts currently held by traders. Each contract is a single trade between two individual traders, one betting the underlying price will rise (long) with the other betting it will fall (short). Before the contract expires, it will be settled with cash flowing from the trader who bet wrong to the trader who bet right. This closes it.
As you can imagine, open interest is generally correlated with the popularity of the underlying market. When a price is rallying and generating excitement, trading activity in that market usually swells as traders rush to participate. But when a price is falling or drifting, demoralized traders gradually abandon that market to seek greener pastures elsewhere. So open interest directly reflects prevailing sentiment.
In gold, each futures contract represents 100 troy ounces. So with this metal trading around $1600, each contract controls big money. If you multiply the gold-futures open interest by 100 ounces and the gold price, it gives you an idea of how much capital futures traders are risking in gold at any time. Like any market, the better that gold is doing the more capital flows in to chase these gains. And vice versa.
This first chart looks at the CoT’s open interest for gold futures since 2001, when gold’s current secular bull was born. The gold price is superimposed in blue. Since the CoT is only published weekly, the gold data is sifted through the same weekly filter. Low open interest in this metal, like we are seeing today, is very bullish. When futures traders wax too bearish and give up on gold is exactly when we want to buy it.
Gold open interest has been in a strong secular uptrend since 2001, which makes sense. The longer gold’s bull persists, and the higher it drives gold’s price, the more traders are interested in participating in this market. Nothing attracts capital like rising prices, which soon form a virtuous circle. Traders buy gold because its price has risen, and their buying pushes it even higher, which entices in still more traders.
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For the great majority of gold’s bull, its futures open interest has meandered within the uptrend channel rendered on this chart. A couple times it broke out above resistance after powerful gold uplegs sparked exceptional excitement in the yellow metal. But as you can see, these upside breakouts were short-lived. Gold soon corrected, bleeding off excessive greed which led open interest to collapse back into trend.
And a couple times open interest broke down below support. The first was during 2008’s once-in-a-lifetime stock panic, where even gold got sucked into that extreme fear maelstrom. All anyone wanted was cash, even gold wasn’t good enough for most during that epic selling event. But the sub-support journey of gold open interest was short-lived, it soon surged back up into trend in 2009 as gold recovered.
Today gold-futures open interest has once again fallen below its uptrend’s support. Back in late April it actually plunged to its lowest levels since September 2009, when gold was trading near $955. While futures traders have driven a slight uptick since, open interest is still very low relative to recent years. And this very phenomenon has proven wildly bullish throughout gold’s entire secular bull.
I highlighted similar gold-open-interest lows with red bars on this chart. When open interest falls far enough to hit its secular uptrend’s support, or is dragged even lower occasionally, this psychological ebb marks the birth of major new uplegs. When futures traders are the most bearish or apathetic about gold, giving up on it, is exactly when this metal is transitioning from correction or consolidation to upleg mode.
Back in early August 2005, gold-futures open interest collapsed to 244k contracts. Since 2003, gold had been trapped between $400 to $450 or so. And after any long consolidation, a sideways grind with no new upside, traders capitulate and walk away. But as you can see above, gold soon launched a mighty rally out of those summer doldrums. By May 2006 it was trading way up near $700 on a weekly basis.
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The bottom line is futures traders’ recent ebb in gold trading is a very bullish omen. They have given up on gold because it has corrected and consolidated for too long, with speculators dramatically reducing their net-long positions. This has dragged down gold-futures open interest as these traders walk away to seek opportunities elsewhere. This is a reflection of bearishness, despair, and capitulation in gold.
But out of similar conditions in the past, the mightiest uplegs of gold’s entire secular bull have launched. When futures traders capitulate and abandon gold is exactly the time to buy. Like traders in general, they are a fantastic contrarian indicator. They get greedy and bullish at major tops and scared and bearish at major bottoms, the exact wrong times. Today’s sorry state of gold-futures trading means this metal is ready to surge.
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