Gold’s Record Selling Overhang

Gold’s mighty new bull market this year has been amazing, the result of heavy buying by investors and speculators alike. But these latter traders have pumped so much capital into gold futures that this metal now faces a record selling overhang. Since the hyper-leveraged nature of futures trading demands an ultra-short-term focus, speculators’ excessive bullish bets on gold pose major near-term downside risks.

Gold’s price trends are overwhelmingly dominated by global investment demand. Even though it has only accounted for about 1/5th of total demand in recent years, investment is wildly variable. With the rest of gold demand relatively stable, it is fluctuating investment demand that ultimately sets gold prices at the margin.Gold’s young bull in 2016 is largely the result of an influx of massive investment buying.

These investors are usually strong hands, expecting to hold gold for the long term as a unique and essential portfolio diversifier that moves counter to stock markets. Gold investors generally buy gold outright, or at worst using the decades-old legal limit of leverage in the stock markets of 2.0x via the leading GLD SPDR Gold Shares gold ETF. Thus normal short-term price volatility doesn’t spook investors into selling.

Futures speculation is an entirely different game. These traders don’t actually buy and sell physical gold, but merely the contractual rights to buy or sell it later in the future at set prices. This is a side game of pure gambling, nothing like investment. Futures speculators never have any intention of buying gold to own it, and they short sell gold they don’t own. Their world is virtual, totally divorced from supply and demand.

But unfortunately the gold-futures price set by their trading has long been considered the benchmark world gold price! The gold-futures bets speculators are collectively making as a herd not only drive but dominate most short-term gold action. Since real investors make their buying and selling decisions based on this essentially-fictional gold-futures price, futures trading has a disproportionate impact on gold.

The sad fact that paper-gold trading far outguns physical-gold trading in determining short-term pricing has long vexed gold investors. This is a major problem because futures speculators’ time horizons are vastly shorter than normal investors’. The extreme leverage inherent in futures trading forces its entire focus to be ultra-short-term. These elite traders have to be momentum players to survive, there’s no other option.

A single US gold-futures contract traded on the CME’s COMEX market controls 100 troy ounces of gold. That’s worth $135k at $1350 gold, a serious sum of capital that excludes all but the biggest traders from the futures realm. If futures had the same maximum margin as stocks of 2.0x, the incentives and time horizons of futures speculators would closely match long-term investors’. But regrettably that’s not the case.

This week, the minimum cash margin required to be deposited for each gold-futures contract was merely $6k. For just $6000, speculators can own the price action of 100 ounces of gold. At $1350, that works out to maximum leverage of 22.5x! Every 1% move in the gold price is instantly amplified into 22.5% gains or losses for speculators.That’s exceedingly risky if not insane, extreme leverage creates extreme risk.

Gold-futures speculators running minimum-margin maximum-leverage would be wiped out, take 100% losses of their capital bet, with just a relatively-small 4.4% adverse move by gold against their bets! Such hyper-leverage is nearly impossible for investors to imagine. And even if conservative speculators keep triple the minimum margin, that’s still 7.5x leverage which is far beyond anything investors will ever experience.

Such extreme leverage demands an ultra-short-term focus, forcing all futures speculators to be myopic momentum players.In order to survive, all they can care about is which direction gold’s next 5% move is heading in.The long-term trends, whether gold is enjoying a secular bull or mired in a secular bear, are almost completely irrelevant.Gold’s likely coming daily and weekly performances are all that matter.

And unlike investors, futures speculators can earn huge amplified gains whether gold is rising or falling.They are totally agnostic, they don’t care either way as long as they bet right.They buy long-side gold futures if they expect gold to rally in the near future.They short sell gold futures if they expect gold to fall in coming weeks.Also unlike investing, these futures contracts formally expire in a matter of months.

This further compounds the extreme short-term focus of futures speculation. Since these traders have no desire to end up owning physical gold, they have to exit all their positions before their contracts reach maturity. This is done by executing the opposite trades. Longs are closed by selling gold futures, while shorts are closed by buying them.This collective gold-futures trading action greatly impacts gold pricing.