The Long and Short of the Gold Market

Jun.29.10 | About: SPDR Gold (GLD)

By Brad Zigler

You need buyers and sellers to make a market like the one in which gold is traded. There's no shortage of players in the gold market presently. There are, in fact, sellers aplenty now. Commercial traders have been building up a net short position that could soon outsize the one that set up gold's December sell-off.

At last count, commercial traders held the equivalent of 326,571 futures contracts[1] short. As of October 20, 2009 — six weeks ahead of an eventual $183 swoon — commercial traders were short 328,344 FCEs.

Commercial Net Short Positions in COMEX Gold Futures

Commercial Net Short Positions In COMEX Gold FuturesClick to enlarge

(Click to enlarge)

So, who are these commercial traders? Well, you can, as the Commodity Futures Trading Commission does, break up commercials into two groups.

The producers/merchants/processors/users contingent includes entities that produce, process or deal in gold and use futures to manage or hedge the risks associated with those activities.

The other lot, swap dealers, use the futures market to hedge the risk of dealing in contracts for gold known as swaps. A swap is a contract calling for the exchange of cash flows. The buyer of a gold swap might agree to pay the dealer a money market return — typically a spread above Libor — in exchange for the return generated by gold from a designated starting point. Swap dealers are primarily investment banks that use futures to manage residual exposures left over after matching long and short commitments internally on their books.

Over the past four years, producers/merchants/processors/users have accounted for 69 percent of commercials' net short positions. Swap dealers weigh in at 31 percent.

The current surge in commercial short positions is an indication that the so-called smart money — those that actually deal in bullion — are growing increasingly concerned about weakness in gold's price. Selling gold futures at today's value, after all, provides them a hedge against the receipt of lower prices in the cash market later.

Does this mean we're due for a gold sell-off? Given current market circumstances, probably. Is this the end of gold's bull market? Hardly. There'd have to be a substantial decline — down to the $830 level presently — to put gold's trend in jeopardy.

Given the six-week lag between the last high net short position and the market's top, we might not see a price break immediately. But its likelihood has increased substantially.

You can use this as an opportunity to lighten or to add to your gold positions as you see fit.

Disclosure: No positions