A Note Of Caution (And Ambiguity) On Precious Metals

Suddenly, gold and silver are good again. In two short months, they’ve morphed from targets of derision to shiny new toys on the financial playground.

Not surprisingly, questions have been pouring in from people who kind-of sort-of know the precious metals story and are wondering if they should jump in with both feet. A reasonable response? “If your time frame is the coming decade, sure, go for it. But if you’re thinking in terms of months rather than years, you should be considering entry points and accumulation strategy.”

Which brings us to the Commitment of Traders (COT) report. Most new precious metals investors have never heard of it. And since it seems to be a pretty good indicator of those metals’ short-term price fluctuations, this might be a useful time to define and explain it. So here goes:

Gold and silver prices are set in the “paper” market where big players trade futures contracts that enable them to buy (or require them to deliver) large amounts of metal at some point in the future. There are two main groups in this market: The fabricators who buy metal and turn it into coins or jewelry or whatever, and the speculators (hedge funds and other institutional gamblers) who use futures contracts to bet on the metals’ price movements.

Over and over again, the fabricators trick the speculators into piling in or out at exactly the wrong time, thus moving prices in ways that benefit the former. They might, for instance, sell a few contracts into the market when most traders are at lunch or home for the night, pushing the price down and activating hedge fund stop-loss orders. Those sales push prices down further, activating technical signals that cause momentum traders to short the market, producing yet another sharp drop. Then the fabricators step in and buy very cheaply — raising prices a bit and leading speculators to go long, pushing prices back up to where the game began. As observers like to say, “rinse, wash, repeat.”