-- Posted Thursday, 18 August 2005 | Digg This Article
Over the past three to four years, I have written quite extensively on the Commitment of Traders report. I have done so in an attempt to demonstrate two things. The first of these is the certainty of official monetary sector intervention into the gold market to control the price of gold. I believe I have demonstrated that sufficiently for anyone who understands how free markets trade. Those essays can be found in the database at lemetropolecafe.com.
The second of these and the one I wish to concentrate on in this essay is the MYTH of commercial superiority in the markets. Having written on this repeatedly in an attempt to correct the errors of those whom I consider to be neophytes when it comes to understanding market structure, I felt inclined to do so just this last time in what is probably a futile attempt to protect the gold community from the Trojan horses that lurk within it. The previous essays providing real life examples of commercial traders making absolute fools out of themselves is provided in the archives at lemetropolecafe.com as well.
Let me again repeat and then prove, for the umpteenth time, that there is no such thing as “all-knowing, all-wise, always-on-the-right-side-of-the-market” commercial traders. The fact that this fallacy is repeated over and over again as if it were some sort of mantra by those posing as “experts” on the gold market, just goes to prove how widespread the deception is and how inexperienced those are who continue to unthinkingly parrot such drivel. It is reminiscent of the famed many-headed Hydra – you cut the head off of it thinking you have disposed of it only to see another head sprout right back up.
The reason I decided to write this last essay on this topic is due to the situation that currently exists in the gold market in regards to the commitment of traders. My inbox has been swamped with fearful gold community members who have forwarded me one link after another containing one essay of doom after another wondering what they should do as they prepare for gold to get knocked back to the stone age once again.
Quite frankly, you have to ask yourself what in the world could the motive be of those scribblers who seem to take some sort of sadistic delight in picking tops in the gold market. As many different markets that I trade regularly, and that is a fair number of them, I have never seen this done in any other market as frequently as it occurs in gold with the occasional exception of silver. One looks in vain for dire warnings of imminent doom awaiting the tech stock junkies during past rallies based on COT analysis.
I suspect many of those who pen such doomsday scenarios for gold are nothing but cheap, second-rate glory seekers looking to make some sort of name for themselves as expert top and bottom pickers, like some sort of New Age market prophet.
I fall back on my old mottos – those that are any good at trading do not need to toot their own horn. Their trading account speaks for them. Secondly, no one can ever consistently catch the absolute top or bottom of a market because we have no idea what the conditions can arise that can skewer the supply/demand situation underlying any market.
Before proceeding to demolish this myth once again and hopefully for the last time for those with open minds, I do wish to state for the record that having been around the markets trading for a living for many, many years, I will be the first to submit that they do and quite regularly do become imbalanced with too many specs on one side of the market and the commercials massed on the opposite side. That is certainly a legitimate point and any seasoned trader will always take care to observe these things. Having been on the wrong side of a spec flush more times than I care to remember, I do not underestimate the ability of a market to move quite severely as all the specs head to the exit at the same time. This point is not therefore in dispute. What I do dispute and will continue to assert and challenge any and all those who continue to spout the notion that the commercial category of traders always are correct and always make money and therefore the specs who trade gold haven’t got a chance.
Let me provide you now with some charts and some commentary to establish the point.
I first of all provide you with a chart detailing the COT for the crude oil contract. I have deliberately left off the dates on the x-axis to demonstrate something important.
Take a close look at the areas circled by the blue dashed lines. It is obvious that there is an extreme imbalance in this market by the time the month of July has come around. All of the specs, including both the large trading funds and the little guys, are on the long side of this market with the “powerful” commercials arrayed against them on the short side. This one is not even close. The specs are long; the commercials are short and have been since February of the year. A massive imbalance is occurring; ergo, it is time for the specs to head for the hills as crude oil is about to get slaughtered as the specs have their heads handed to them.
I can almost see the commentary now. “SPECS IN MORTAL DANGER”; “COMMERCIAL POSITIONING INDICATES COMING SELL OFF”; “IT’S CLOBBERING TIME FOR THE SPECS”; et cetera, et cetera, ad nauseam, ad infinitum.
I will now direct your attention to the crude oil chart that covers this same period and you can look for yourself and see the results. The year is 1999.
Notice particularly the price at which crude oil was trading when the commercial category moved over to the short side of the market. It was $12.24/bbl. Refer back to the above COT data chart and you will see that for remainder of the entire year, the commercials were net short. Crude began at $12.24 when they made their transition and it ended the year at $25.60 with the commercials still remaining net short. In other words, the price of crude DOUBLED all the while the “all-wise and always-on-the-right-side-of-the-market” commercials remained net short. That by the way turns out to be a mere profit of better than $13,000/contract for any specs who rode that market all the way up through out the year along with a corresponding loss for any commercial who did the same thing.
Now zoom in a bit and look at the circled the area where the first imbalance occurred when the commercials first reached their largest net short position of the year. That occurred in the month of July as you can verify by again referencing the COT data chart previously displayed. Had the same “expert COT analysts” that now run rampant through the gold community been plying their wares back then, chances are pretty good they would have been at it with their “sky is falling” warnings.
What did crude do from that point? Apart from a brief dip of around $1.50/bbl in August, it ran all the way to $25/bbl before correcting in October. In other words, the market ran another $5.00 with the largest imbalance to that date occurring. Any spec who ran in fear simply because someone might have told him or her that the mighty commercials were arrayed against them, ended up leaving $5,000/contract on the table for someone else to pick up. That is not exactly how trading fortunes are made!
Yes, crude did have a violent correction, finally, in the month of October, as the imbalance did finally tip over but notice that the market recaptured the entire retracement down and went on to soar $7.00 higher before peaking at $27/bbl. Again, all the while the commercials were net short.
What is the point in all this? It is actually quite simple – no one knows how far an imbalance can continue before the market tips over. As a matter of fact, if the fundamentals justify a move, a market can exist with a spec/commercial imbalance for far longer than most expect all the while with the commercials on the losing end of that trade.
The reason for this is that commercial entities that actually produce the underlying commodity are concerned about the risk of falling prices. There are supposedly using the futures market to hedge and lock in production costs and thereby offset risk. In the case of crude oil above, any producer who has crude to sell wants to lock in a sale at a cost that allows them to show a reasonable profit. Once they can do that, they will sell enough futures contracts to cover the amount of crude in question. If the price continues to rise, whatever they lose on their short futures position is more than offset by the gain they make in the physical market when they actually sell the physical crude oil. What do they care at that point? They have a guaranteed profit with no risk having assigned that risk to a speculator. That is why they can sit on the ‘wrong” side of the market for what seems an eternity. It is not necessarily a sign that they have chosen the “right” side as so many seem to think.
Keep in mind that true commercials are seeking to avoid price risk – they are not speculators attempting to ride a long term trend and make their company’s fortunes by speculating in the market place – that is the business of the risk takers known better as speculators. Far too many people who pose as experts in the area of COT analysis seem to have forgotten this basic principle. Of course, even the commercials are not averse to actually making a profit on their futures positions, but that is incidental to their main purpose for participating in the futures arena. As a matter of historical fact, more often than not, commercials who forget this are prone to losing big sums of money and I do mean big sums. Those are the ones that get reported in the financial press when their trading division ends up costing the firms millions of dollars due to rogue in-house traders who forget they are not speculators.
Let’s take another look at a COT data chart for the same market, this time for the year 2004.
Notice that they are several periods throughout the year in which the specs are arrayed against the commercials who are once again on the short side. You will also notice that in May of the year, the small specs went over to the short side leaving the trading funds on the long side all by themselves.
What did crude oil do for the year of 2004? Answer – see the chart below…
It began the year at $32.52 and ended the year at $43.45 after having peaked above $55.00. Question… who was on the right side of the market for the bulk of the year, the funds or the commercials? Answer – the funds.
By comparing the two charts for the year of 2004, you can observe some interesting points.
Refer to the COT data chart and you can see that there were two periods, one in March and the other in May in which all the specs were on the long side of the market and the commercials on the short side. In both cases, the market did indeed experience a setback in price the latter of which was very steep. This is an instance in which the call for a short term top based solely on the COT data would have been a correct one. However, notice how beginning in late June the funds began rebuilding their long positions. The resulting move was phenomenal to say the least. They drove the market from $35 to $49 in a matter of seven weeks time. Where were the commercials during this entire move? Yep – you guessed it, they were short again having actually been squeezed out of some of their short positions in early August for a while as the fund buying was too much for them.
Now some might argue that the commercials were proven right because the market did finally set back in late August dropping from $49 to $41. It is true that the price set back; however, the rally off the June low near $35 was good for a $14 gain whereas the retracement was $7.00.
Look what happened after that. The funds came right back in and bid the market back up, this time taking it from $41 to slightly over $50 in early October for a $9.00 gain. This is where things get very interesting.
Look closely at the price chart where I have a red ellipse drawn around a band of prices in early October when crude was trading near $50. If you compare the price action with the COT data chart something jumps out with crystal clarity. A huge commercial short squeeze took place. The commercials were caught flat footed on the wrong side of the market and the funds took it to them. You can see that the commercials were reducing their short positions in the second week of October while the funds were slowly closing out their longs all the while price was climbing. In other words, the trapped commercials, who no doubt had bet that crude would not better the $50/bbl mark paid dearly for their miscalculation. They had no choice but to run or face financial distress probably having gotten giddy with prices at such dizzying heights and turned into speculators trying to make some quick bucks for their firms instead of simply being prudent hedgers. Their forced buying took the price of crude oil up another $5.00/bbl in two weeks time bringing it to the $55.50 mark.
Meanwhile the long funds simply smiled and said, “thank you” and sold off their hugely profitable longs to the panicked commercials. What is interesting is to further observe the chart from the end of October into early December where you can see that as price dropped precipitously, the funds were closing out more longs while the commercials this time were adding longs. In other words, the funds were selling to the commercials as the price dropped down from $55 all the way back to $40.
Once again I state the obvious – the commercials were short for most of the year 2004 as crude ascended in price only to be forced out driving the market up to $55 before prices peaked as their buying was met by fund selling booking profts both on the way up and on the way down.
We could repeat this scenario over and over and over again giving multiple instances across a broad spectrum of markets. Such an effort will clearly show that the notion of the commercial category of traders always make money in the futures markets or are always on the correct side is simply rubbish which is nothing but a market myth that has now taken on a life of its own due to constant repetition.
I repeat, no market can ever be predicted based SOLELY on the COT data and the more people that attempt to do so, the more foolish they are going to look. It is high time to put a stake through the heart of this Dracula-like myth and to get traders to think for themselves instead of blindly following some “guru” spouting COT numbers as if he were some mystic leader with peculiar insight into the markets.
Again, I wish to emphasize, I am not dismissing the validity of COT analysis in attempting to trade. I myself use it quite extensively having written as much about it if not more than most anyone out there. I do indeed put great stock in it. But there is a right way to use it and a wrong way to use it and anyone who suggests one can successfully trade by using the COT data as some sort of stand alone technical indicator is asking for a world of financial hurt. It is not the holy grail of trading as some seem to think that it is.
One last thing and I am done. I also hear chatter that once cumulative open interest totals reach levels in which previous price setbacks have occurred that it is near automatic that they will do so again. Similar to the myth of commercial superiority, this too is bunkum.
Let me provide a few more charts to demonstrate this. I will use the same market that we have thus far examined, namely, crude oil.
Refer back to the first chart I used in this essay which was for the year 1999 and recall that in July of that year the imbalance between specs and commercials became quite severe. We have already covered the implications surrounding that occurrence. What I would like you to focus on is the actual open interest total that month. If you look closely at the chart, I have noted it as 626,985.
I included the previous year, 1998, to provide a frame of reference. Notice that when the imbalance occurred in July 1999, open interest was 160,000 contracts larger than the same time period in 1998. That is no small matter as participation in the crude contracts was enormous at the time. One could have made the same argument concerning crude oil back then that I hear being made today concerning gold, to wit, open interest totals are in record territory and a massive imbalance exists between specs and commercials who are short. “Specs, head for the hills!” We have already seen how foolish that would have been.
Keep in mind that number 626,985. it is important as you will see shortly.
Now fast forward to the year 2004 in the chart below where this time I provide the open interest along with the price data of crude oil including the years 1998 thru the present to give you a panoramic view.
What is fascinating to observe is that while open interest was setting new highs in 1999 no doubt causing consternation among “expert” COT analysts, in 2004, open interest only twice dipped briefly BELOW the highest level it had reached in 1999. This is important to understand. For just about the entire year of 2004, open interest was at levels that had not been experienced even at the greatest point of imbalance existing between specs and commercials in the year of 1999.
What is my point in all this? Simple – no one knows how high open interest can climb in a powerful raging bull market. Period! Who could have foreseen in 1999 that a mere 5 years later, open interest would be regularly trading 100,000 contracts more than the peak reached that year? Anyone who went on the record to state that once “open interest approaches 640,000 contracts, a top is in the crude oil market” and tried using that fallacious reasoning in 2004, would have appeared to be a complete and total buffoon based on past analysis of the crude oil market.
Fast forward now to this year’s crude oil market in which we have already seen open interest obliterate previous peaks in both 1999 and in 2004 as well. Look at the chart and observe that the open interest is nearly ONE MILLION CONTRACTS in crude oil having hit 930,000 already. Can it go higher yet? Sure it can and why not?
Imagine trying to take even the analysis from 2004 and stating categorically that “once open interest exceeds the record level in 2004 near 740,000 contracts, a top is sure to occur in the crude market”. What utter nonsense!
Can you not, dear reader, see by now that those who continue to distress the gold community with their warnings of imminent collapse in the gold price now that open interest has exceeded 320,000 contracts are simply filling the air space with vapid words? How do these prophets know that this is the ceiling for open interest in the gold market? Upon what do they base this claim? How can they prove that there exists no further room for specs to pile into the gold market should conditions warrant such?
I am going to make this prediction and put it in writing here in this essay for future reference so that in the event I am wrong, my critics can cite my own writings to me and wave their finger in face all the while scolding me for how foolish and wrong I was – before this generational bull market is over, open interest in the gold market will exceed 500,000 contracts.
There it is. I have no fear in stating this categorically without the slightest caveat.
Those of you who believe in gold for all the fundamental reasons that historically have benefited gold, will see a day in which commentators will be stunned at the amount of buying that comes into the gold market as the general public begins to move out of tech stocks and into the yellow metal in the process driving open interest to levels inconceivable in the minds of so many of these short-sighted “experts” who are nothing but legends in their own mind.
Dan Norcini
August 17,2005
Dan is a professional off-the-floor commodity trader residing in Texas and can be reached with comments at dnorcini@earthlink.net
-- Posted Thursday, 18 August 2005 | Digg This Article
