Friday July 26, 2013 14:24
Futures speculators have responded to this year’s extreme bearishness plaguing gold by amassing wildly-outlying record short positions in it. These huge and highly-leveraged bets can only be unwound by buying gold futures to cover the shorts. As gold continues rebounding out of its recent hyper-oversold lows, the futures traders on the short side will have to buy. This will likely fuel a massive short squeeze.
Major short squeezes are the stuff of market legends, rare and extreme events. Whenever a price falls particularly far and fast, traders wax exceptionally bearish on it. They extrapolate the downside action continuing indefinitely, and some want to play that momentum. So they reverse the usual trade of buying low then selling high. They effectively borrow the asset from someone else to sell it in the open market.
Naturally whatever is borrowed must be repaid. If the short sellers are right, if the downtrend continues, they can buy back the underlying asset later at a lower price. They strive to sell high then buy low, the difference pocketed as gains. This buying to return the underlying asset to its original lender is called covering. It’s in this covering that short squeezes are born, when prices turn against the traders shorting.
Unlike normal long trades, short ones have unlimited risk. The biggest loss possible when buying an asset outright is 100%, at worst it goes to zero. But there is no limit to how high prices can be bid up, so the worst-case loss on a short is theoretically unbound. This attribute puts tremendous psychological pressure on shorts when trades move against them. They have to cut their losses as soon as possible.
When the prices of heavily-shorted assets start rallying rapidly, this covering dynamic quickly feeds on itself. Initially a small fraction of short traders buy to exit their bets. But their very buying accelerates the rally, spooking progressively larger fractions of their peers. So they rush to buy too, forming a vicious circle. The covering shorts are squeezed out of their positions by their own buying, fueling big rallies.
These short squeezes can cascade into full-blown buying panics. These are the opposite of the usual selling panics, igniting some of the biggest and fastest rallies ever witnessed. Several factors greatly increase the odds for spawning a buying panic. They are exceptionally-large short positions for the underlying asset, excessive leverage among the short traders, and hyper-oversold price conditions.
All exist in spades today in the US gold-futures market, which implies high odds for an enormous and imminent short squeeze. Speculators’ short positions in gold futures are at a wildly-outlying secular-bull record high. And these futures traders are running extreme leverage of up to 16 to 1, radically ramping the speed and magnitude of their losses during a gold rally. And boy is gold sure overdue to surge higher!
The yellow metal was hammered to its most-oversold levels by far of its entire dozen-year secular bull near the end of last month. In just 9 months, gold plunged far enough to surrender a third of its value! This pummeled it down to an unprecedented three-quarters of its 200-day moving average. Such an extreme selloff would herald a giant mean-reversion recovery for any asset, and gold is certainly no exception.
This first chart looks at the total long and short contracts held by large and small gold-futures speculators as defined by the Commodity Futures Trading Commission in its famous weekly Commitments of Traders reports. Total spec longs and shorts are rendered in green and red respectively, with the gold price superimposed on top in blue. Speculator gold shorts have just surged to a stupendous outlying record!
The CFTC releases its CoT late every Friday afternoon, current to the preceding Tuesday. So the latest available data when this essay was published was Tuesday July 9th’s. And it is truly stunning. Gold-futures speculators held the short side of an astounding 178.9k contracts that day! This was at least a 12.3-year high, the most-extreme gold-futures spec short position by far in gold’s entire secular bull.
The sheer size of this bearish bet is breathtaking. Each COMEX gold contract controls 100 troy ounces of the yellow metal. So American futures speculators have borrowed and sold 17.9m ounces, or 556.4 metric tons! That even dwarfs the also-outlying record selloff in the holdings of the flagship GLD gold ETF over the past 7 months, which now weighs in at 417.3t. This epic gold short is wildly unprecedented.
The risks of such a big downside bet on gold are mind-boggling. By definition, futures speculators don’t produce or consume the commodities they trade. They aren’t gold miners, so the only way they can repay the 556.4t of gold they’ve borrowed is by buying it in the futures market. But even that won’t be easy. 556.4t is the equivalent of a fifth of total global production from all the world’s gold mines last year!
In order to amass such an enormous collective bet on further gold downside, futures speculators have to be both exceptionally bearish and highly convicted about that worldview. This is especially true given the very high leverage inherent in futures trading. High leverage makes already-unforgiving short selling an extraordinarily risky game, greatly multiplying both the speed and magnitude of losses when gold rallies.
At $1250 gold, a single 100-ounce futures contract controls $125,000 worth of the metal. But traders don’t have to put up the full $125k to play. The minimum maintenance margin on COMEX gold futures contracts these days is just $8k. This means the maximum leverage available to aggressive gold shorts is 15.6 to 1! Stock traders can scarcely comprehend that, as stock margin has been legally limited to 2 to 1 since 1974.
At maximum leverage, a mere 6.4% gold rally would wipe out 100% of the capital risked by gold shorts! While not all futures traders run with minimum margin, plenty do. The faster that gold rallies, the more pressure it puts on these guys to buy offsetting futures longs to cover. Short squeezes are born when just a small fraction of traders are forced to cover, unleashing buying pressure that sucks in many more.
The power of this futures leverage to violently move prices shouldn’t be underestimated. It is actually the dominant factor responsible for most of gold’s extraordinary losses this year. Year-to-date as of its recent late-June low, gold had lost $474. Incredibly $285 of this, or 60%, happened on just 3 trading days. First in mid-April and then in late June, the very high leverage inherent in gold futures fueled selling panics.
Every futures contract is a deal between two traders, the buyer on the long side and seller on the short side. And this is a zero-sum game, every dollar won by one trader is a direct dollar loss for the opposing counterparty. Back in April and to a lesser extent in June, gold plunged so fast that the max-leveraged speculator longs were forced to sell. Their selling greatly exacerbated gold’s selloff, sparking that vicious circle.
This cascading dynamic amplified gold’s down days to 4.7%, 9.6%, and 5.1%, enormous selloffs. The leveraged futures traders didn’t even have a choice. With gold moving so fast, brokerage margin computers stepped in to unilaterally sell longs at any price to protect their firms from having to make good on their customer traders’ losses. High leverage amplifies big moves as trapped futures traders are forced out.
This is true both ways, on exceptional down days and exceptional up days. Just as plunging prices drive forced liquidations of longs, surging prices drive forced buying by shorts. The brokerages unilaterally close these risky positions by buying at any price, and that buying pressure amplifies the rally which forces out more shorts. Today’s bull-record gold-short position among speculators is like short-squeeze rocket fuel.
After plummeting so rapidly in 2013, largely driven by the high gold-futures leverage biting the longs, gold is hyper-oversold and due for a massive rebound rally. If that happens fast enough, the shorts will be forced to buy to cover rapidly and trigger a short squeeze. The US futures markets have a long history of every contract being honored, there are no defaults. So the vast gold shorts can only be closed by offsetting buying.
Obviously speculators willing to run 10-to-1-plus leverage are much more sophisticated than your average long-only stock trader. High leverage is very unforgiving, quickly weeding out the traders who don’t know what they are doing. Nevertheless, as a herd gold-futures speculators have a long track record of making the wrong bets at price extremes. They miss major reversals as they get too fixated chasing momentum.
When gold-futures speculators are the most bearish, as evidenced by relatively high total shorts and relatively low total longs, gold is nearly always in the process of carving a major bottom. I highlighted instances of this in light blue above. These are major gold lows leading into major new uplegs where the futures speculators were utterly convinced gold would continue heading lower. Their track record is dismal.
A great example is the last secular-bull-record short position held by gold-futures speculators in early 2005. With gold near a major low, longs plunged to 145.1k contracts while shorts surged to 108.3k. This extremely bearish bet by the futures traders was dead wrong though. Over the next 15 months or so, gold would blast about 65% higher in its biggest upleg of its secular bull at the time. High spec shorts are a bullish indicator.
And with gold merely near $425 at this bull’s last record high in spec shorts, they were risking far less capital than they are today with gold near $1250. Those 108.3k contracts then controlled $4.6b worth of gold, but the recent outlying-record 178.9k contracts controlled a staggering $22.4b worth of gold! The more extreme the futures speculators’ shorts, the more guaranteed buying exists to catapult gold higher.
This next chart looks at a second episode of extreme futures speculator bearishness during 2008’s once-in-a-lifetime stock panic. That was the last time the spec longs in gold futures were lower than today’s, revealing extreme bearishness. Spec shorts were way above average too. Yet it was a terrible time to bet against gold, as this metal would dramatically power 167% higher over the next several years or so.
At peak bearishness during the stock panic, futures speculators’ long and short gold positions fell and rose to 144.7k and 84.5k contracts. These guys, with nearly everyone else, were utterly convinced gold was dead. If it couldn’t rally during an ultra-rare stock panic with the greatest market fear anyone will see in our lifetimes, then when would gold ever rally? The bearishness in it then was absolutely universal.
Yet nearly all traders, even the sophisticated leveraged futures guys, bet wrong at price extremes. They are the most bearish after long exceptional selloffs when they should be the most bullish. That happened in late 2008, it happened at this secular bull’s other major gold lows, and it is happening again today. These big short positions are actually what fuels the early rallies out of lows, when they’re often the only demand.
Shorts have to cover, they have effectively borrowed gold from other traders that has to be repaid. And the smart ones want to buy after extreme selloffs, to close their successful downside bets and realize their profits. But buying isn’t always easy. Every futures contract requires a willing buyer and willing seller. And as a price starts surging out of major lows, there aren’t many traders looking to sell gold futures.
So as shorts bid on gold futures to cover, in a short-squeeze situation there’s insufficient supply. The shorts dominate the market and a large fraction of them want to buy. But the longs who bought low are not interested in selling to the shorts in a nascent rally likely to run much higher. So in order to buy to cover, the shorts have to keep raising their bids to attract sufficient supply which accelerates the rally higher.
That classic dynamic was very apparent in late 2008’s stock panic, when gold started surging dramatically out of the depths of despair on gold-futures short covering. And compared to today, both the peak speculator shorts and gold price were much lower then. So the shorts then only had $6.6b of forced buying they were legally and institutionally bound to do, compared to the utterly staggering $22.4b today!
If that last episode of extreme bearishness among gold-futures speculators led to gold nearly tripling, how much more bullish is today’s far-greater extreme? In the post-panic years between 2009 and 2012, total spec long and short positions in gold averaged 288.5k contracts and 65.4k contracts. Merely to mean revert to these levels, not even overshoot, will require incredible gold-futures buying in the coming year.
On the long side, speculators would need to buy 91.6k contracts (9.2m ozs or 284.9 metric tons) to just return to post-panic-average long levels. Unlike the shorts who have to buy to repay the gold they’ve borrowed, this buying is optional for the longs. But as we saw after the stock panic, nothing brings back futures longs like rapidly rising prices. In under only a year after late 2008, longs were once again high.
The average futures-speculator short position in gold in the 4 full years after 2008 and before 2013 was 65.4k contracts. That is a long way down from today’s outlying-record 178.9k short position, we are talking 113.5k contracts! This is a mind-boggling 11.4m ozs of gold, or 353.1t. And unlike the longs, this buying is not optional. All this futures gold borrowed and sold short has to be repurchased, full stop.
Add these mean reversions from extreme lows in speculator gold longs and extreme highs in speculator gold shorts, and you get highly-probable buying in the coming year of 20.5m ounces or 638.0t! This is the equivalent of nearly a quarter of total world mine production in 2012! And all this is atypical exceptional demand on top of all the normal gold demand throughout any given year. So much buying is wildly bullish.
And I just can’t see how an exit from such outlying-record gold shorts when gold is at hyper-oversold lows and due to surge can be orderly. At some point, gold is almost certain to rally as fast as it plunged on the down days when the long futures traders were trapped in forced liquidations. And with such massive and highly-leveraged short positions, a short squeeze cascading into a buying panic is highly likely.
The total buying pressure on gold as it rebounds is going to be unprecedented. On top of the futures mean-reversion buying, there is the 417.3t of GLD holdings that had to be liquidated since December as money managers dumped gold. When gold starts rallying decisively again, they will realize they’ve made a mistake in portfolio allocation and migrate back in. GLD holdings should recover to new record highs in a year or two.
On top of all this exceptional buying, with wildly unprecedented 1055.3t potential between gold futures and GLD, is gold’s strong season. Much of gold’s enormous secular-bull run has been driven by huge buying out of Asia. The strong season over there begins with harvest in August, and runs for months on end. And unlike dumb American investors who foolishly like to buy high, Asian investors love bargains.
They are going to buy like never before with gold so extremely oversold and at such incredibly low levels compared to the past couple years. This is going to put even more pressure on the gold-futures speculators to exit their short positions. We are truly set up for a perfect storm of gold buying after 2013’s perfect storm of gold selling. The futures-short-driven component of that selling has to and will reverse.
And while a short squeeze in gold will work wonders for it and silver, the price impact on the viscerally-loathed and apocalyptically-oversold miners will be awe-inspiring. In late June as gold hit its most oversold levels of its secular bull, the miners were literally left for dead. Their flagship index was trading at exactly where it first traded 9.8 years earlier when gold and silver were merely priced near $390 and $5.25!
The bottom line is the record short position futures speculators have amassed in gold is wildly bullish for the yellow metal. These guys have a long track record of betting completely wrong at major gold lows, extrapolating major downtrends continuing indefinitely even when they’ve begun reversing. This grave error leads to forced buying as the rallying gold price forces the shorts to cover their hyper-bearish bets.
And given such extreme spec gold shorts, widespread despair, and gold recently hitting the most oversold levels by far of its secular bull, it is due for a monster upleg. As this accelerates, the leveraged shorts will be forced to buy back the gold they owe at increasing rates. This will feed on itself and likely ignite a buying panic. It will very likely lead to the biggest and fastest upleg of gold’s entire secular bull.
Adam Hamilton, CPA