Should Gold Bulls Panic After Friday's Gold Drop?

by: Hebba Investments

Friday's gold drop was painful for gold bulls.

If not for Friday's action, gold would have been up for the week.

Commercials continued to increase POSITIVE bets on gold.

Gold was the only precious metal covered in the COT report that showed Commercial bullishness.

Single day drops don't make or break a good investment, and we think gold is still attractive here.

The latest Commitment of Traders (COT) report showed gold speculators increased their long positions for the week by 4,000 contracts, while shorts cut back on their positions for a second straight week. All of this was just in time for Friday's big gold price decline, which was not reflected in this COT report.

In last week's article, we mentioned the massive increase in Commercial gold positions, but the gold price ended up down the week despite this. In fact, we had some colorful Seeking Alpha comments upset (or excited) about the price drop - we blacked out the names to protect the innocent (these folks have families after all):

What is interesting is that the gold price was actually UP for the week before Friday's drop - so essentially the one-day drop meant that the "Commercials don't know anything". Unfortunately, that is the wrong way to look at COT reports and trading in general - investors need to be able to ignore the noise and keep their emotions in check. One day drastic drops will happen (especially in gold and precious metals), and investors need to be able to look at price action in a more balanced fashion and understand that they will lose some battles when trying to win the war.

What is even more interesting? Commercials added to their long positions with the latest COT report and that was before Friday's big drop, so we expect their long positions to be even higher based on the negative price action.

We will get more into some of these details, but before that let us give investors a quick overview into the COT report for those who are not familiar with it.

About the COT Report

The COT report is issued by the CFTC every Friday to provide market participants a breakdown of each Tuesday's open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. In plain English, this is a report that shows what positions major traders are taking in a number of financial and commodity markets.

Though there is never one report or tool that can give you certainty about where prices are headed in the future, the COT report does allow the small investors a way to see what larger traders are doing and to possibly place their positions accordingly. For example, if there is a large managed money short interest in gold, that is often an indicator that a rally may be coming because the market is overly pessimistic and saturated with shorts - so you may want to take a long position.

The big disadvantage to the COT report is that it is issued on Friday but only contains Tuesday's data - so there is a three-day lag between the report and the actual positioning of traders. This is an eternity by short-term investing standards, and by the time the new report is issued, it has already missed a large amount of trading activity.

There are many ways to read the COT report, and there are many analysts who focus specifically on this report (we are not one of them) so we won't claim to be the experts on it. What we focus on in this report is the "Managed Money" positions and total open interest as it gives us an idea of how much interest there is in the gold market and how the short-term players are positioned.

This Week's Gold COT Report

*Gold price data reflects the COT week (Tues-Tues) not a standard week (Mon-Fri)

For the week, speculative longs increased their positions by 4,189 contracts while shorts cut back their own short positions by 2,317 contracts. Gold closed the COT week (Tuesday) at $1,298.65, but since this COT report closed before the big Friday drop, we expect the actual gold speculative positions to be much more bearish (or bullish for contrarians).

Moving on, the net position of all gold traders can be seen below:

Source: GoldChartsRUS

The red line represents the net speculative gold positions of money managers (the biggest category of speculative trader), and as investors can see, we saw the net position of speculative traders increase to 65,000 net speculative long contracts. In terms of the historical range, the speculative positions are now standing at some of the lower levels on the 10-year chart.

Despite this, gold commercial entities continued to increase their long positions for a second straight week to one of the highest in the past few years, though nowhere near the amount they did last week.

*Gold price data reflects the COT week (Tues-Tues) not a standard week (Mon-Fri)

Is there something going on behind the scenes in the gold market that we are unaware of to cause Commercial traders to increase longs and cut back on short positions? We do not know, but the big reasons why Commercials would cut back on gold positions are (1) because their inventory is decreasing (remember they short to cut back on price risk for their gold inventories) or (2) they sense the market is going to tighten and have little worry about a much lower gold price.

Out of the four precious metals covered by the COT report, gold was the ONLY ONE where Commercial traders increased long positions and cut back on short positions. We are very curious to see next week's report and see how Commercial entities reacted to Friday's price drop.

As for silver, the last week's action looked like the following:

Source: GoldChartsRUS

The red line which represents the net speculative positions of money managers showed the speculative position increase by around 35,000 contracts in silver as speculative longs added to their positions while shorts slashed their own levels. This was a massive increase in the net-silver position and suggests that silver speculators may have gotten a bit ahead of themselves.

Our Take and What This Means for Investors

Another week of bullish activity in Commercial longs causes us to remain bullish on gold. As for silver, the massive increase in speculative activity would have made us bearish, but Friday's action more than likely cut back significantly on this speculative activity. That means we remain both Bullish on gold and silver as we enter this new week.

We think it is time for investors to consider adding to their gold positions and silver positions through some of the ETFs (SPDR Gold Trust ETF (NYSEARCA:GLD), iShares Silver Trust (NYSEARCA:SLV), Sprott Physical Silver Trust (NYSEARCA:PSLV), and ETFS Physical Swiss Gold Trust ETF (NYSEARCA:SGOL), etc).

Disclosure: I am/we are long SGOL, SIVR. 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.