The Anomalous Open Interest Pattern of the Gold Market

When it comes to the gold market, forget what you have learned from most of the trading books out there when it comes to interpreting the open interest data in light of price action.

Conventional wisdom tells one that rising prices along with rising open interest and good volume is a sign of a healthy bull market. Conversely, rising prices accompanied by decreasing open interest and decent volume is a sign of a bull market that is getting ready to run out of steam to the upside. Kiss that all goodbye in the new world of managed markets. Let me state here for the record that the exact opposite is true now that the lords and barons of the official sector have decided to impose their will on the peasants and surreptitiously pervert the natural order of the gold market.

To begin with and for the sake of clarification, let me define the term "open interest". Open interest is the number of contracts outstanding or "open" in the various futures markets. For each buyer, there must be a seller. Whenever a NEW buyer meets up with a NEW seller and one contract is exchanged, the open interest count increases by one. Thus, if open interest is rising, that tells us that both new buyers and new sellers are entering the fray. These new buyers are obviously convinced that prices are headed higher. The new sellers on the other hand are convinced that prices are headed lower. As the two sides gather their forces, open interest begins to build. It is this build up which typically provides the fuel for markets to make a sizeable run in one direction or the other as one side eventually "blinks" and throws in the towel.

For an illustration of what "normally" takes place in the average futures market, let's take a commodity whose price is rising and examine it so as to make our point clear. I have chosen a particular favorite - the soybean market. Soybeans are very liquid and quite volatile at times - two factors which contribute to their continuing popularity among futures traders. Furthermore, beans tend to establish very clear and definite trends and will thus lend themselves quite well for our purpose.

If you look closely at the chart and notice the August 2003 time frame you will see soybeans moving up quite nicely from the 533 region to the 800 region with nary a pause. Refer to the open interest graph (green line) and you will see it headed steadily upward as well. According to conventional technical analysis this was a healthy bull market. Both bulls and bears were convinced of the soundness of their judgment as new buyers were being met by new sellers. Since it is obvious that the shorts were losing, any sellers who were throwing in the towel were being replaced by new sellers at higher levels. The supply of losing shorts was thereby being constantly replenished while new longs were flexing their muscles.

Near the middle of October, things began to change a bit as apparently longs felt that $8.00/bushel beans were pretty fairly priced and thus they began to take some money off the table and close out some of those longs put on during the last three months. Consequently, soybeans became locked into a sideways trading range for the next couple of months while players waited for the fundamental picture to clear itself up which occurred just as 2003 was closing out.

The rise from 800 in January, 2004 to 1060 in mid March was accompanied by rising open interest totals; again a bullish sign (red lines) - however a chink was appearing in the armor of the longs. Open interest levels failed to exceed the earlier peak reached some four months earlier back in October when beans had peaked at 800. This was a clear warning that bullish enthusiasm was beginning to wane as bullish traders were getting overextended. The market was telling us that new longs at these levels were getting harder and harder to come by.

The market ran back up to the 1060 region in early April, 2004 but once again open interest levels could not exceed the previous peaks. It had become obvious that the new longs were finished buying and that the shorts who were going to run had already done so. Without a fundamental change of some sort, the market had no where to go but down. In two weeks, beans dropped from 1060 to near 935 for a whopping price move of $6,250/contract. Longs were bailing out in droves as evidenced by the steep fall in the open interest graph. However, an amazing thing took place beginning in mid April (blue line). For the next three weeks, soybeans ran right back up 125 points retracing the entire down movement that just took place and moving all the way back into the 1060 region once again. Bullish? Guess again!

This time however the technical aspect of the soybean market had now changed. How do we know that? Simple - this entire up move in beans was accompanied by shrinking open interest totals (see the first blue line). The shorts were running this time around and it was their buying that was propelling bean prices northward. The bulls were not taking any chances this time around either and were using the panic buying of the shorts to liquidate their long positions. This is a CLASSIC EXAMPLE of a bearish open interest situation - RISING PRICES ACCOMPANIED BY SHRINKING OPEN INTEREST as it is a clear indicator of short covering taking place. A savvy trader would have having been alert to this and would have sold into the price rise since once the bears were finished buying back their short positions, THERE WOULD BE NO ONE LEFT TO BUY and prices would reverse.

That is exactly what happened. Prices collapsed in mid May from 1060 all the way down to 806 - a stunning $12,700 move per contract in a little over two weeks. A counter trend rally occurred lifting prices back up again throughout the entire month of June, but notice that once again, RISING PRICES WERE ACCOMPANIED BY FALLING OPEN INTEREST TOTALS - a classic bearish setup. Again, at the risk of redundancy, the buying that drove prices up in the month of June was that of shorts who were being squeezed out. As soon as this buying was done and the last desperate short was forced out, bean prices were obliterated dropping from 1035 to 583 in a month's time - $22,600 per contract. That my friend is not exactly chump change!

I have spent a fair amount of time examining the soybean market to show the mechanism that takes place in a freely traded market when one side eventually realizes that the gig is up and that they are on the wrong side of the market. Once that point is reached, these losing positions are going to be closed out in furious fashion either as the result of forced liquidation due to margin calls or through downright fear as traders trapped on the losing side simply bail out en masse fearing financial ruin. Nothing runs a market faster than the emotion of fear - not even greed!

The point is that eventually the losers are forced to deal with the harsh reality of insufficient capital. What makes this process so efficient and yet so relentlessly merciless is the clearing mechanism. Each day all trading accounts must be settled. The trader with winning positions is rewarded by seeing the day's paper winnings credited to his account; the trader with losing positions is punished by seeing his paper losses debited to his account. In effect, the losers subsidize the winners as someone's loss is someone else's gain. Futures-trading is indeed a zero sum game.

Once this process is completed, all accounts are then compared to the margin requirements necessary to maintain the current position makeup of each trader's accounts. For the day's winners, this is usually not a problem. The losers are the ones that have good cause to be concerned. Should the balance in their trading accounts fall below the sum needed to maintain their current positions, the infamous margin call results. Let me briefly describe how and why this occurs before proceeding on to the gold market in particular.

The particular exchanges set the margin requirements for the various contracts traded at their sites and have complete disgression as to what those amounts might be. The brokerage houses will be required to see that each of their customers is sufficiently capitalized to meet these minimum requirements but they can go one step further. They can require additional sums to be on deposit in their customers' accounts at their own disgression. Should the customer's daily paper losses result in his or her account falling below the sum of monies needed to maintain their positions, they will be required to either deposit more money in their account to bring their account balance up to initial margin requirements or liquidate the positions that have caused the losses and thus do away with the need for margin. That is the essence of a margin call. The brokerage firm "calls upon" the customer to supply additional funds to meet the minimum amount of money necessary to control the contracts they are attempting to trade.

At this point, most traders have NO CHOICE but to get out of these losing positions or pony up more cash to meet margin calls. The former is usually opted for as there comes a time in even the most stubborn of trader's lives where they have to accept defeat and move on if they are to survive long enough to trade again. This is the simple but brutal reality of futures trading. Throwing good money after bad is like throwing money down a rat hole. Sooner or later you wise up and realize that you are getting nowhere.

When we come to the gold market however, none of this applies! The simple truth is that which far too many of the gold "experts" are unable or unwilling to comprehend, i.e. the single group of traders who have consistently been on the short side of the gold market for the last four years DO NOT RUN regardless of the price action. No matter what the size of their paper losses they never seem to run. Losses that run into the $billion range seemingly do not matter. That is simply unheard of in the realm of futures trading. The proof of this assertion is contained in the Comex Gold Continuous chart for the last four years.

Keep in mind the axiom I have laid down - losers eventually run out of money and are forced to abandon their positions due to insufficient capital to meet margin calls. In the process of so doing, the open interest begins to contract revealing the exit of these losing traders. With that in mind examine the gold chart below and look at each peak in the gold price and then look at the open interest graph directly above the chart. I have drawn a dashed vertical line to facilitate the analysis. Notice that at no time during the last four years have we experienced anything remotely resembling the soybean chart in our previous example. Not once has the gold price moved sharply upward while accompanied by FALLING OPEN INTEREST. Again, to repeat in a slightly different manner - not once in the last four years have those playing the short side of the market been run out of the market while it has powered upward. Without exception, the entire rise in the price of gold has been met by FRESH SELLING.

As a trader of many years experience, I will challenge anyone to find a market, any market, which exhibits this self-same characteristic as gold (for that matter silver as well) in which the losers on the short side never run. I can spare you the time in advance should one be foolish enough to accept the challenge - You will not find one!

I have demonstrated in some of my previous essays that these commercial traders who consistently meet all fresh buying with fresh selling and consistently absorb that buying until they can eventually overpower it when a news story or government report favors their cause have sustained huge paper losses (upward near $1billion at times) with seeming impunity. This begs the further questions - "How are these perma-shorts able to meet daily margin requirements necessitated by the exchange clearing process? What kind of internal processes within a corporate structure would permit unrealized trading losses of such magnitude without the plug being pulled on the operators? Is there some sort of tacit agreement between the official sector authorities and the operators in which the daily losses are "guaranteed" by the official sector? "Why does this phenomenon occur only in gold (and silver more often that not)"?

The sad but all-too-real truth is that if a group of market participants have advance knowledge of potentially market moving news or reports and/or action by government authorities that will be favorable to their positions, they can meet all bids with impunity and sit on loss after loss after loss as eventually a point will be reached where the market temporarily runs out of buying impetus and a cascading chain reaction of mass selling can be precipitated in which those who have been incurring enormous trading losses can recoup most it not all of those losses as frustrated longs bail out in disgust. They can then regroup and repeat the process over and over again.

This past week we were witness to this same sort of overt price capping in the gold market once again by the same category of commercial traders which are none other than the bullion banks. On Thursday, September 30, gold had a massive up day in which it powered through long standing resistance near the $417 region basis December on rather heavy volume. The following day's release of the open interest data revealed a shocking nearly 23,000 NEW positions were added in the December 2004 contract. The price rise had been met by a wall of fresh selling once again. If there were any shorts who did indeed run for the hills, there was ONCE AGAIN, no shortage of fresh selling by the same group of people who have been raping the general public for the last four years. As soon as that data was released, it was obvious that a raid on gold was coming at the earliest convenient opportunity. This time it happened to be around the context of the G7 summit which failed to issue any statement confirming a general dollar devaluation or urging an ending of the Chinese yuan peg. The usual knee jerk reaction followed and down went the gold price once again. It is all too familiar to those who have observed the gold market over the last few years.

What is particular interesting is that many of us who closely track the gold market have now gotten so in tune with the tactics of these ambushers of gold, that we can correctly anticipate their activity in the market by tracking the market internals and actually profit off of it accordingly. Still, that does nothing to compensate the multitudes who are regularly fleeced by these people nor does it compensate the millions of shareholders who have invested in the stock of gold mining companies whose market capitalization regularly suffers during the "hunting season" of the commercial bullion banks.

There is more than a bit of consolation however for gold investors and traders who are fed up with this increasingly brazen and overt display by these operators. Take a look back at that same gold chart above and this time forget about all the dashed vertical lines and focus on that dashed blue trend line drawn underneath the price. In spite of all their infernal meddling, gold continues to power onward and upward. Their efforts to derail it are proving as self-defeating as spitting into a hurricane. Each time gold is knocked down it finds support at higher and higher levels.

So go ahead bullion banking boys, give it your best shot. Go ahead and sell it down - we will be there to buy it from you. The hundreds of thousands, if not millions of us who believe in the yellow metal, will have the last laugh and see the day when your defeat is final and ignominious. You are losing; we are winning. Requiescat en pace!

October 5, 2004

Dan is a professional off-the-floor commodity trader residing in Texas and can be reached at [email protected] with comments.