Gold’s technical breakdown suffered in its recent capitulation selloff naturally unleashed a flood of bearish sentiment. Traders are totally convinced gold’s woes are just starting, that the worst is yet to come. This pessimistic worldview is largely universal, even among futures traders. But their collective bets are actually a strong contrarian indicator. Their bearishness peaks right before major rallies erupt.
Futures speculators are generally considered the most sophisticated of traders. With futures’ inherent high leverage, margin requirements, limited lifespans, and zero-sum nature, they are far more risky and challenging to trade than stocks. Thus the average futures trader is much better informed and better capitalized than the average stock trader. Unforgiving futures trading soon weeds out mediocre traders.
But nevertheless the surviving futures traders are still human. They struggle with the same dangerous emotions of greed and fear that plague stock traders. As a herd, futures traders grow too euphoric and greedy after a price has surged too far too fast. So they flood into longs near highs. And they get too despondent and fearful after a price has plunged too far too fast. So they pile into shorts near lows.
And the latter has certainly happened recently thanks to gold’s capitulation. As an unfortunate chain of news and sentiment fed on itself as analyzed in depth in our latest monthly newsletter, futures traders grewexceptionally bearish. So they made big bets that gold’s price would keep on falling, which in the futures world means taking the short side of contracts. And these shorts reached incredible extremes.
US futures trading is regulated by the Commodity Futures Trading Commission, an arm of the US government. While the CFTC can be a real pain sometimes like all regulators, one good thing it does is publish a weekly report called the Commitments of Traders. Released late Friday afternoons, it shows what positions several classes of futures traders happened to be holding as of the preceding Tuesday.
Futures are a zero-sum game, every contract has one trader betting a price will move one way against an opposing trader betting that price will move the other way. So every dollar won in futures is a direct dollar loss from the counterparty on the other side of the contract. Thus the total number of longs and shorts in any commodity, including gold, are always perfectly equal. Shorts can’t exist without offsetting longs.
While total gold shorts always equal longs, the CFTC divides futures traders into three different classes. These are commercial traders, non-commercial traders, and nonreportable traders. These are generally translated as hedgers directly using a physical underlying commodity for business purposes, large speculators, and small speculators. The aggregate positions held by each class can vary considerably.
The way it nearly always works in the gold world is commercial hedgers mostly take the short side of gold contracts. They are dominated by miners locking in future selling prices. And then speculators, both large and small, take the offsetting long side of these trades. When the total longs and total shorts for each class are added up, the result is a net-long or net-short position. This effectively reveals sentiment.
The more net-long the speculators are, the more bullish they are on gold. They won’t make these risky leveraged bets on this metal unless they are convinced it is likely to continue surging. This tends to happen near major toppings after big uplegs. The less net-long speculators are, the more bearish they are on gold. They won’t bet heavily on gold upside after this metal has long languished in corrections.
This first chart looks at these aggregate class positions in gold futures over time. The always net-short commercial hedgers’ positions are shown in yellow. Without them, gold futures trading wouldn’t exist. The offsetting net-long large and small speculators are rendered in orange and red. When the gold price is overlaid on these collective positions, it becomes readily apparent they are a strong contrarian indicator.
Even though commercials are always net-short and speculators always net-long during a secular bull, the degree of these bets is very revealing. As speculators get exceptionally bullish or bearish on gold, their net-long exposure rises and falls accordingly. And amazingly given futures’ traders well-deserved reputation as sophisticated players, they nearly always make the wrong bets near gold-price extremes!
