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Gold Futures - #6 - An Educational Series - Trey Reik

Gold Futures - #6 - An Educational Series - Trey Reik
By Sprott Global Resource Investments Ltd. 3 years ago 2425 Views No comments

Trey Reik is a Senior Portfolio Manager and Precious Metals Strategist at Sprott Asset Management USA, a division of Sprott Inc., a Toronto-based alternative asset manager. He is also the author of The Sprott Precious Metals Watch, a monthly newsletter produced by Sprott Asset Management LP.

March 8, 2016

In a recent article which explores the current pricing environment for gold, Sprott Senior Portfolio Analyst Trey Reik discusses the impact of the U.S. dollar, the state of the current credit and business cycles, and the pricing activities of other commodities. He also examines gold’s positioning in the futures markets.

So here comes a crash course on futures markets, and the information we can pull from them.

What is a futures contract?

A futures contract is simply an agreement between a seller one who agrees to deliver a commodity and a buyer one who agrees to receive the commodity who agree to exchange the good (in this case, gold) at a future date, price and location. As the contract is an agreement to sell, not an actual exchange, we consider futures contracts to be derivatives, much like options. The value of the futures contract (gold, for example) is derived by the price movement of spot gold, not from any inherent value in the contract.

Futures contracts are traded on a regulated, centralized exchange, and participants generally may use leverage. This allows for greater liquidity, more efficient pricing and greater visibility into the markets. For those concerned with the gold market, it allows insight into the opinions of the actual end users of the market, as well as speculators, and can be an interesting gauge of market sentiment.

Who participates in the futures market?

The futures market is primarily made up of parties with an interest in hedging. Hedgers take a position in the market that is the opposite of their physical position. Due to the price correlation between futures and the spot market, a gain in one market can offset the losses in the other.

When it comes to gold, Trey notes that jewelers, manufacturers and bullion banks are generally positioned “net short” in the futures market. They already have a physical store of gold on hand, which they could use to make delivery of the gold to the long position if necessary. Hedge funds and money managers are large speculators, and they are generally “net long.”

Why do Producers use Futures?

A mining company is an excellent example. A mining company most often will use a futures contract to lock in the price of the gold they are producing. This allows the executive team to more accurately plan their budgets.

The futures market essentially provides pricing certainty for the producers and end users, and has been a tool for farmers, energy producers, miners, and money managers to reduce volatility in their portfolios or production since the first futures contract was traded in 1951 for corn.

What are the Futures Markets telling us now?

Unlike the equity markets, wherein stock holders will not recognize gains or losses until the day they sell their stock, futures contracts are settled every day. Therefore these markets are highly liquid and prices depend on a continuous flow of information from around the world. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand of the contracts. This kind of information and the way people absorb it constantly changes the price of a commodity. [1]

Trey provides this Commitment of Traders (“COT”) chart in his report. [2]


Explain the Chart

The COT report essentially shows the positions for each available futures contract for three different types of traders. If traders are overwhelmingly long or increasing their long positions, then we will have a bullish bias. Similarly, if traders are short or increasing their short positions then we will have a bearish bias.

Not all traders in the report are of equal importance, and the CFTC breaks out the major market participants for us. Commercial traders represent companies and institutions which use the futures market to offset risk in the cash or spot market, i.e. farmers and mining companies hedging their production. Non-Commercial Traders (large speculators) include large institutional investors, hedge funds and other entities that are trading in the futures market for investment and growth. They are typically not involved directly in the production, distribution or management of the underlying commodities or assets. Non-Reporting Traders (small speculators) is the catch-all category for traders too small to be required to report their positions to the CFTC. [3]

The green line in the chart above maps open interest. It is simply a measure of the flow of money into the futures market: the total number of outstanding contracts that are held by market participants at the end of the day. This is an important trend meter, which is shown as a positive or negative number and illustrates rate of change. For example, if both parties to the trade are initiating a new position (one new buyer and one new seller), open interest will increase by one contract. Open interest will decrease by one contract if the buyer and seller close out their position. If one old buyer sells to one new buyer, but no new contract is initiated, the open interest will not change. [4]

In January, we saw the open interest in gold decline dramatically, and net short positions were at their lowest levels in many years, indicating commercial users were closing out their contracts—prices were so low, there was no need to hedge. By the end of February, this had changed dramatically, with commercial traders vastly increasing their short positions. This would indicate that commercial traders are currently attempting to lock in current prices, taking advantage of the price bump. In the short term, it appears they do not expect prices to increase.

An interesting conclusion from this dramatic swing is an indication that volatility in the markets has returned, a much hoped for catalyst for investors in the space which has been wracked by declining trading volumes (and let’s not forget prices!) for the last several years.

[1] Perry, Brian. "Beginner's Guide To Trading Futures” Investopedia. Investopedia, 04 Sept. 2012. Web. 02 Mar. 2016. .

[2] "Current Commitments of Traders Charts." Current Commitments of Traders Charts. SoftwareNorth LLC, 23 Feb. 2016. Web. 02 Mar. 2016. .

[3] "Commitments of Traders." CFTC. U.S. Commodity Futures Trading Commission, 23 Feb. 2016. Web. 02 Mar. 2016. .

[4] "What Is Open Interest and How to Profit from It." TradingPicks.com, n.d. Web. 02 Mar. 2016. .

The author is not affiliated with, endorsed or sponsored by Sprott Money Ltd. The views and opinions expressed in this material are those of the author or guest speaker, are subject to change and may not necessarily reflect the opinions of Sprott Money Ltd. Sprott Money does not guarantee the accuracy, completeness, timeliness and reliability of the information or any results from its use.


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