The gold-futures and silver-futures short positions held by speculators have rocketed up to extremes in recent weeks. These elite traders are aggressively betting for further weakness in gold and silver prices. But history has proven extreme shorts are a powerful contrarian indicator. Right as speculators wax the most bearish as evidenced by their collective bets, gold and silver decisively bottom and birth major new rallies.
Futures trading has a wildly-outsized impact on gold and silver prices, especially over the short term. It is amazing how much volatility futures speculators’ collective buying and selling generates, often drowning out everything else. Two factors are responsible for this dominance. The extreme leverage inherent in futures trading and the unfortunate fact the resulting gold and silver prices are the world’s reference ones.
Normal investment capital flows occur with no leverage, the vast majority of stocks and bonds are bought outright. So buying and selling isn’t multiplied. Some stock traders use margin, which for many decades has been legally capped at 50% in the US. So they can borrow up to half their stocks’ purchase prices, or run 2x leverage. That gives any given capital flows, buying or selling, twice the price impact of outright ones.
But futures speculation allows truly extreme leverage, in a league of its own. US gold-futures contracts each control 100 troy ounces of gold. At $1250, that’s worth $125,000. But the margin requirement, the capital necessary in a trading account to hold that contract, is just $3950 this week. That enables traders to run leverage as high as 31.6x! That acts as a strong price-impact multiplier on all their buying and selling.
Silver futures are similar, with US contracts each controlling 5000 troy ounces. That commands $80,000 worth of silver at $16. But this week traders are only required to put up $5000 in cash to buy or sell each contract. That makes for maximum leverage of 16.0x, well under gold’s extremes but still enormous by normal-market standards. Futures effectively greatly amplify the price impact of relatively-small amounts of capital.
Every dollar of gold and silver buying and selling by outright investors has one dollar of price impact. But at 32x or 16x leverage, every dollar speculators move into or out of gold and silver futures has the same short-term price impact as $32 or $16 of outright investment! This extreme leverage grants these futures speculators wildly-outsized influence over price action. This is incredibly distorting and super-unfair to investors.
But unfortunately that’s the way the markets work these days. Compounding futures trading’s extremely-disproportional price impact, the resulting gold and silver prices have long been considered the world’s reference ones. So big gold and silver moves fueled by futures speculators can greatly affect universal sentiment, convincing other traders including investors to follow futures speculators’ lead exacerbating moves.
I sure wish this wasn’t the case. Without the extreme leverage inherent in futures speculation, gold and silver prices would be far less volatile and more closely reflect global physical supply and demand on an ongoing basis. But because futures traders’ capital flows are so radically multiplied, all investors and speculators interested in gold, silver, and their miners’ stocks have no choice but to closely follow futures action.
There’s one key way to do that, through the weekly Commitments of Traders reports published by the US Commodity Futures Trading Commission. Released late each Friday afternoon but current to the preceding Tuesday close, the CoTs detail speculators’ total long and short positions in gold and silver futures. Analyzing these weekly changes in collective bets and their trading ranges over time is very illuminating.
The CoTs break down all futures traders into three categories, hedgers, large speculators, and small speculators. The hedgers produce or consume physical gold commercially in their businesses, and use futures to mitigate gold-price risks to their operations. The speculators take the opposite side of hedgers’ trades, as futures are a zero-sum game. I lump both large and small speculators together for analysis.
This simple chart superimposes the daily gold price over the weekly total long and short gold-futures contracts held by speculators. Their long contracts, bullish bets that gold is heading higher, are rendered in green. And their short contracts, bearish bets that gold is going lower, are shown in red. It’s impossible to understand short-term gold and silver price action unless you closely follow this weekly data from the CoTs.
The reason I’m writing this essay is the past couple weeks’ gold-futures developments are exceedingly bullish! Speculators have taken on a massive new leveraged short position in gold as evidenced by the soaring red line. They are wildly-bearish as a group, totally convinced gold is heading lower in coming weeks and months. But after every past gold-futures shorting extreme, gold has instead blasted sharply higher!
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