Holy Hedge Fund Shorting: 'Game On' For Gold And Silver

Includes: AGQ, DGP
by: Dave Kranzler

The emergence of technical fund and speculative short selling has created the finishing touches to a market structure set up that is good to go in gold and maybe in silver as well... The bottom line is that an important price low is being put in, if it has not been seen already. - Ted Butler

I wanted to follow up on my article last week that analyzed the Comex Commitment of Traders (COT) for gold futures. I had suggested the likelihood that the recent increase in the gold futures short position of the large hedge funds, and the concomitant large reduction in the net short position of the commercial traders (mainly the bullion banks), was a signal that this vicious price correction in gold/silver is nearly over.

The COT report released Friday (through Tuesday's cut-off day) was nothing short of stunning. I knew the hedge funds were piling onto the short side of gold and silver, and that's why the metals have been getting slaughtered recklessly like this. But the increase in the hedge fund gold short position is unprecedented, as far as I know. In other words, I can only recall one or two times when even the big banks increased their gold short by this much.

Let's look at the numbers -- here's the COT report in table format from the Got Gold Report:


The red numbers that I've circled above represent the increase in Comex gold short interest for the large hedge fund and retail trader (small specs) categories. With gold, the hedge funds increased their gold short by 23.7K, while the banks (Producer/Merchant and Swap Dealers) covered 28.5K. The small specs increased their short position by an incredible 18.6%, or 5.3K.

Here's a graph going back to the last Friday in April 2005, which shows the weekly hedge fund gross short interest, the big bank net short interest and the price of gold:

As you can see, the hedge fund short position is at a record level. I show the big bank net short position because it captures both the magnitude of short-covering and the increased gross long position of the banks. The black circles show the points in time when the hedge fund gross short position and the bank net short position converge in magnitude. You can see what happens to the price of gold when this dynamic occurs.

It's important to remember that hedge funds typically do not deliver or take delivery of the actual physical metal. What this means is that, ultimately, as the price of gold heads higher, the record large hedge fund short position will create a "rocket fuel" effect on the upward movement in price as the hedge funds scramble to cover their shorts. We saw this particular dynamic in operation during gold's last rally last August-September. This time around, the hedge fund short position is significantly larger.

The other point of note from the COT report table above is the relatively large short position of the "non-reportables." This category is also known as the small speculator category -- the individual retail "trader" who is chasing momentum. These poor fellows are going to get annihilated unless they rush to cover their short positions.

The bottom line is that the extreme short interest position of the large, momentum-chasing hedge funds (and the individual speculator) has created what has historically been a very bullish set-up in the structure of the COT report. Although I would expect that initially, the hedge funds will make some intra-day attempts to defend their extreme short interest position by shorting even more, I suspect we'll see the next week or so punctuated with rallies in the metals toward the end of the trading day. This occurred in silver on Friday.

The best way to position for a big move higher in gold and silver is to buy into the leveraged ETFs, like AGQ (2x the rate of return on silver) and DGP (2x the rate of return on gold). One strategy I started to pursue last week for my fund was buying some AGQ and shorting near-money calls against the position. The particular "spread" I put on last week locks in a 10% (outright, non-annualized) return on capital through the March 16 options expiry in the event that AGQ closes above the strike price of the call by the March 16 expiration. If the price correction continues a bit longer, we get to keep the AGQ position at what I consider a great entry price, but our net cost of entry will be reduced by the amount of the premium we collected from shorting the calls. In addition to scaling into AGQ like this, I will be putting on an outright long (non-hedged) position in AGQ over the next few weeks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The fund I manage is long AGQ, short AGQ calls and long physical gold and silver.