Last week I noted a significant increase in the Commercial traders opposition to the rallies in gold and silver. At the same time, managed money had almost closed all of their short hedges and were buying the rallies without fear. I noted this is the sort of COT action one expects before a major correction. I also stated that the COT data is a lagging indicator- because it takes a snapshot of the trader positions from Tuesday to Tuesday, but only publishes them the following Friday, one has to take a guess what has happened in the meantime. For me the most important use of the COT is to look for contradictions to the norm. Take a few months ago. Silver had come to rest around the 26 level after a strong correction from 37. Many commentators were looking for the next leg down- however the COT data strongly contradicted this view as the commercial traders had one of their smallest net short positions of all time! In this case the COT data did not help with predicting the choppy sideways movement of silver that ensued, but it did place a floor under the price. In essence the COT data said-' I can't tell you how silver is going to trade over the next few weeks, but I can tell you, significant downside is very unlikely at this time.' A savvy trader could have then established a long term call option with relative safety, relying for profit, not on predicting the price action in the weeks coming, but knowing that at worst it would hang around 26 and at best it would eventually rally. And boy, after some hesitation, did those PM's rally!
So now we find ourselves after a huge rally in the inverse position we did all those months ago at 26. Instead of more downside being called by many commentators, suddenly it seems everyone is predicting higher targets. Once again as we reach extremes in the market, the COT becomes very helpful if we use it in a binary manner- i.e it either contradicts or supports the historical norm for COT data. For example the most unusual thing right now would be if the COT report was showing a falling short position by the commercials and a low long position by the managed money (if in effect the COT positioning at $26 silver was similar to now, $6+ higher). If the COT showed this I would probably be selling my house and buying all the silver I could find because this would signal that unlike all previous rallies, the commercials were not opposing this one and the managed money were not getting overexcited- in short the COT data would be a massive contradiction compared to its historical norms. Unfortunately for any members who have just sold their house and bought all the silver they could find- the COT is not contradictory at this time. In fact it is running with all the predictability of a finely oiled machine- as prices get higher the commercials get shorter and the managed money gets longer. Last week this situation increased over the week before; this week it has increased over last week. Both weeks the prices of metals were higher than the week before. In essence the COT, if looked at from a binary perspective, is saying what it always says when prices rise too fast too far- this rally isn't going to last!
Lets look at the numbers:
In silver while prices rose 4.7% Tuesday to Tuesday, the commercials increased their net shorts by a large 6.3k contracts, and their shorts as a % of open interest is now 37.6% (up from 31.7% last week) - the highest level since Feb. 28th 2012. The sub section of the commercial category known as producer merchants strongly opposed the rally and added 10% to their net shorts (producer merchants are usually the slowest to react and so once they start opposing rallies heavily with shorts, time is running out for the bulls).
It is worth noting that open interest in silver actually fell this last week- this means that shorts are being covered quicker than longs opened, and suggests that the price rise is being dictated by the physical market. This is unusual and is something to keep an eye on. If it continues then it may indicate something else is going on- i.e there is a shortage of silver available for delivery or that price discovery is being slowly moved from the comex to the physical markets. Until i see mass backwardation in the futures strip, for now this is simply something to keep in mind, especially as it is not occurring in the gold market.
In gold the numbers were even more bearish than in silver. As gold rose 1.7% Tuesday to Tuesday, to 1695 the commercials added 7% to their net shorts and they are now short a massive 49.4% of the entire market. The highest since Feb. 28 2012. Since July the gold price has increased 7.3% but the commercials have increased their shorts by 61%- this is a very large increase relative to the price gain. Unlike silver, open interest rose and so price discovery is clearly being led by the futures market.
The COT will never tell us with accuracy of a top or a bottom. Most of the time the COT data is useless. However, if used in a binary sense- if the data is looked at relative to past data and only heeded at extremes it can be very useful. Back at $26 silver it signaled a rare contradiction- it showed commercials were unusually small in their short positions, despite price stabilizing for some time in the 26 range. This was very useful and could be traded upon from a longer term perspective (i.e buy Silver 40 puts expiring in Feb. 2013) as it put a floor under the price of silver with high probability. The trader could then exit his position if the COT data began to change, or as happened, simply wait for silver to break out to the upside as the COT report suggested would occur. We now find ourselves in a different situation- in effect we are in a 'normal' COT situation that happens again and again during rallies in Pm's- Commercials getting shorter and managed money getting longer. It is vital to understand that although this is the opposite COT situation as when silver was at $26, it is not equally 'important' . This in fact is the 'norm' for COT reports. Back at $26 we saw something very strange, what we are seeing now is completely expected.
The COT report is a bit like a grouchy neighbor with a very short temper- a party pooper. As the houseparty gets wilder, the COT trying to sleep next door gets more opposed to the revelry. Sometimes the party can go on a long time, the COT tossing and turning getting more and more angry. Often the COT rings the neighbor and screams down the phone- signaling the party must stop. Usually, those partying ignore the neighbor on the phone and continue the party, perhaps even turn up the music. Eventually the COT has had enough- he bangs on the door, orders everyone out and calls the cops. The revelers, who only minutes before were enjoying the time of their life, wander dazed through the cold streets searching for a cab home.
Recently with silver at $26, grouchy COT did something extraordinary he had never done before- he saw his neighbor bringing supplies in for another party, and catching his young neighbor's eye, he said in a gruff voice, 'have a good party, just don't let it get out of hand.'
We have seen old COT begin to mellow. It is a fascinating thing to watch. Although it hasn't happened during this latest rally, I am always looking for the final act- the party to end all parties. You know how I'll know it is beginning?
At midnight, as the party begins to rock there will be a sharp knock on the door. The revelers open it to find grouchy COT standing on the porch, holding a bottle of Jack Daniel's. 'Mind if I join?' he asks, a grin on his face....
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.