Published : August 06th, 2013
I've been emphasizing for months that the current correction in
the gold price is a result of speculative money fleeing the market and
not any reflection of gold's long-term fundamentals. Unfortunately,
there is so much money to be made (and lost) by day trading that my
cautions have once again fallen on deaf ears.
Well, it looks like
the so-called "technicals" are starting to support my theory, and so
this month I'm going to depart from my typical discussion of market
fundamentals and take a look at the COMEX gold futures market. It turns
out that the same paper markets that helped drive the price of gold down
are beginning to run into the hard reality of physical gold demand;
their reversal may push gold to new highs.
Reading the Futures
The
world of futures contracts is often confusing for ordinary investors.
It is mainly the domain of institutions seeking to hedge and
professional speculators. I do not recommend passive investors get
involved in futures trading, but it is helpful to understand how these
financial instruments affect gold's spot price.
In its most basic
form, a gold futures contract is an agreement to buy a set amount of
gold at the current spot price with delivery guaranteed at a future
date. The attractive part is that you don't need to pay the full price
up front. You can put a down payment on 100 ounces of gold today,
knowing that you will only have to complete the payment when the
contract comes due. If the price of gold rises in the intervening time,
you've made a nice profit, because you end up paying today's price for a
product that is worth more in the future. Of course, the person who
sold you the contract takes a loss for the same reason. The person
buying the contract is said to be "long" gold, while the seller is
"short."
One of the reasons gold futures are so risky is because
of the sheer quantity of gold that transactions represent. When you buy a
single COMEX gold futures contract, you gain control - and
responsibility for - 100 troy ounces of the yellow metal. So when the
gold futures market was said to have made "big moves" this last April,
that was an understatement - on April 12th, it opened with a sell off of
100 tons of gold!
It gets worse. Traders often leverage
(borrow cash) to buy futures contracts, with the down payment they
supply known as the "maintenance margin." The minimum maintenance margin
for a single futures contract is only $8,800. If spot gold is at
$1,300, then a trader can gain control of $130,000 worth of gold with
less than 7% down! Depending on a combination of luck and experience,
this massive leveraging can lead to either amazing profits or
devastating losses.
Let's walk through an example, keeping in
mind that my figures are very simplified, because a futures contract is
not exactly equal to 100 times the current gold spot price. Most of the
time, futures prices are a little higher than spot gold.
Say gold
is at $1,300, which means a COMEX gold futures contract gives the
investor control of about $130,000 worth of gold. A trader buys a
contract with only a $8,800 margin. If the price of gold goes up to
$1,500, the futures contract is now worth $150,000. The trader can now
sell that contract and pocket the difference. He just netted about
$20,000 with only $8,800 in seed money. If the trader had simply bought
$8,800 worth of physical gold, he would have only earned about $1,350 in
the same time period. It is not hard to see how futures trading can
seem exciting and profitable on its face.
But what if the price
of gold goes down in this scenario? The more the price of gold drops
below the contract price of $1,300, the more the investor will be
required to add to his margin to maintain the same ratio of down payment
to loan value. This is required as assurance that he will not abandon
the contract. In the worst case scenario, the trader cannot put up the
additional funds and the entire position is liquidated by his broker.
So
far, this example is of a trader "going long" with a futures contract.
It can be risky, but the potential losses of a long futures trader are
nothing compared to the losses someone shorting the market might
experience.
Consider the same scenario above, except this time
the trader has a short contract. He is desperately betting that the
price of gold will drop enough for him cover his short position (buy
back the contract he sold) at a lower price. After all, he can not hold
the contract to maturity, as he does not actually own any physical gold,
and thus would not be able to deliver to the buyer.
The key difference between long and short traders is that shorts are forced to add to margin when the price of gold goes up. Unlike
a drop in the price gold, which can only go so low, there is
theoretically no limit to how high the price of gold can rise.
Someone betting on gold's demise with short futures contracts when gold
enters a big bull market can be completely devastated by their margin
calls.
It's risky enough leveraging into a deal as aggressively
as futures traders do, but if traders don't understand the fundamentals
of the asset underlying the contract (in this case, actual physical
gold), they can get into a lot of trouble and in turn distort the price
of the commodity they are trading. This is precisely what is happening
now.
The Short Squeeze
When gold began its price
drop in April, we saw a rush of paper gold flee the market, including
record-high ETF outflows. Major money managers and hedge funds began
selling their gold positions, issuing lower and lower forecasts for the
year-end gold price. All of this became a major signal for futures
traders to short gold.
The selling feeds on itself as the traders
seek to cut their losses, or retain some of the paper profits the
earned on the way up. Sometimes the selling is fueled by "stop sell
orders," which are orders on the books that are automatically triggered
when prices decline to a specific level, in many cases just below key
technical support levels. Stops generally become market sell orders as
they are hit, accelerating the decline and thereby triggering even more
stops as prices fall lower. Some stops represent long positions being
covered; others represent new short positions being established.
This
ongoing shorting of gold builds a cycle that feeds on itself. The
shorts see others fleeing the market and so continue to short.
Meanwhile, the fund managers see the net-short positions increasing and
so they continue to sell gold.
This cycle continued right up until gold's rebound - in July, the gold net-short positions reached record highs.
When
gold began to rebound last month, a massive number of shorts were left
exposed and many still remain exposed. Gold shorts are stuck holding the
losing bet on an asset that is going to do the opposite of what they
anticipated.
If the price rally continues, these traders will
feel increasing pressure to unwind their shorts before their losses
become catastrophic. This "short squeeze," as it is known in finance,
will reverse the vicious cycle and could send gold dramatically higher
than when the correction started.
An Unbalanced Ecosystem
To
understand this short squeeze, imagine a brand new predator entering a
pristine natural ecosystem. The newly introduced predator finds a
smorgasbord of prey that have never learned to outrun, outsmart, or
avoid this particular predator. Before long, the predator becomes
"invasive" and begins to devastate the natural population of its
easily-captured food source. Thriving on the newfound resources, the
population of the invasive predator surges to new highs - until the prey
population collapses.
This is akin to what has happened with
gold shorts in the past three months. The more the price of gold (the
prey) was driven down, the more gold speculators (invasive species)
entered the market to profit from this trend, which only served to drive
the price down further.
However, as in a natural ecosystem, this
relationship is unsustainable. Eventually there are so many predators
that they run out of enough prey to share. This forces the predators to
starvation, and eventually the population drops to a sustainable level
while the prey manage to grow back to a natural equilibrium.
The
overwhelming problems for the shorts is that the gold they sold on the
way down will not likely be for sale on the way up. My guess is that the
buyers who previously stepped up to the plate were not short-term
traders like the speculators who sold. These were buyers who bought gold
to own it, not to trade it. For these buyers, like foreign central
banks, the gold they bought is not for sale at any price (at least not a
price the speculators can afford to pay). The buyers over the past few
months have been lying in wait for this opportunity for years.
The
result of this price decline is that gold has moved from weak hands to
strong. In addition, the weakness in the price of gold has caused gold
miners to shut mines, reduce capital expenditures, and limit
exploration/development. So gold that was once on the market will be
gone, and future supply coming from new production will be diminished.
So when the market turns around, how will the shorts cover? Where will
the gold they need to buy come from? When traders want back into the
ETFs, where will the ETFs get the physical gold they need to buy? How
much higher will prices have to rise to bring that supply back onto the
market? I really have no answers to these questions, but it sure will be
fun for the longs, and painful for the shorts, to find out.
What
you and I can really hope for is that this massive short-squeeze
becomes the impetus to focus the market back on gold's fundamentals and
begins to drive the yellow metal back toward its previous highs. If I'm
right that gold is still grossly undervalued, then this might be the
beginning of the biggest rally we've yet seen.
