We've discussed the first quarter commodity rally in detail over the last two weeks. Our general opinion has been that these rallies are temporary as commodity producers use this opportunity to hedge forward production at decent prices for the first time in over a year. This week, we'll discuss the metal markets - gold, silver, platinum and copper. We'll detail how we used the Commitment of Traders report to pinpoint the market's bias as well as how to factor external shocks into the current picture. Finally, we'll provide some support levels as we look to take profits on the current decline.
Let's begin with the background of our methodology and mechanical programs. Our thesis remains, "No one knows a single market like a company whose livelihood is tied directly to the fluctuations of that market." The Commitment of Traders (COT) report categorizes this group of traders as, "commercial." They either produce or, consume the commodity in question and their actions in the futures markets are based on their business model's sense of value. Logically, commodity producers will sell more of their production at prices they perceive as overvalued while commodity consumers will load up on purchases that they feel are being executed at bargain prices. We track their net position, total position and open interest percentage along with the prices at which they're taking action to determine the importance of given price levels.
Considering all of these factors sets us up with a chart similar but, not identical, to the one below. There is only room for so many data streams before the chart becomes illegible.
Once the COT criteria are met, the mechanics of setting up the signal are very simple. We use a short-term market momentum trigger that serves two primary purposes. First of all it keeps us out of the market most of the time. As you can see on the discretionary COT chart, we've averaged barely one trade per month. Our selectivity allows us to focus on true reversal potential. Remember, this is generally a mean reversion or, value based strategy. Therefore, we wait for the market to turn, as verified by our short-term momentum trigger prior to entering the market. This shows us that the market has at least, begun a reversal. Time always tells if it will hold. Secondly, by waiting for a turn, it provides us with a protective stop point for our discretionary, chart based, signal service. Meanwhile, our mechanical COT programs utilize percentage based stops that are quantitatively based.
Without disclosing the exact logic behind the reversal calculations, let me share some of the COT report's recent statistics that put us on the lookout for short selling opportunities in the precious metals. Remember, the Commitment of Traders report is a publicly available weekly report published by the Commodity Trading Futures Commission (CFTC). These are data points anyone can track.
Copper
Commercial traders sold more than 45k contracts between January 22nd and today.
That selling increased the commercial traders' control of the market to 47% of the open interest....they're highest percentage since the June decline.
Finally, large speculators held their largest short position in more than 10 years at the January's dead low....which got shoved right up their wazoo.
Gold
Large speculators reached their largest net long position since 2012 last week. This is another classic example of speculators having their largest positions on at the most inopportune moments.
The large speculator position was more than offset by corresponding commercial trader selling as commercial traders have sold nearly 100k contracts during last week's congestion.
Lastly, commercial traders controlled more than 50% of the total open interest. Their behavior compared quite favorably to the October sell-off analog.
Platinum
Speculators tried to stem platinum's decline dating back to the June sell-off, which saw them set a record long (and wrong) position.
Last week, we saw commercial traders take control of the market's open interest just as it did in gold.
Lastly, the commercial traders' surpassed their short position total from the recent October highs. This indicated their willingness to sell more at lower prices, which is obviously very bearish.
Silver
Commercial traders, as determined by their net position, have not been this bearish on silver since 2008. Remember, silver traded from $21 per ounce all the way down to $8 and change before the 2011 rally.
By comparison, the large spec position at the October highs was the largest it had been in more than 10 years. It has been proven over and over again and again, the market punishes the greedy. Speculative traders are greedy by nature or, they wouldn't be trading commodities in the first place.
Lastly, the commercial traders controlled a whopping 55% of the open interest prior to Wednesday's decline.
Finally, on the topic of exogenous shocks to the market, while I hate having to comment on Brussels, I must. The Brussels tragedy had the predicted effect of driving last ditch safe haven buyers into the markets. Given the weak response by those actions and events, it was clear that the metals markets had been, "bought out." Therefore, the market needed to fall to find additional support through lower prices attracting new buying.
Obviously, the question is, "Now what?" We've got some profit in these short positions so; here are the logical Fibonacci levels down to the 50% retracement. Much activity below this level would probably put us on the lookout for new lows for the move but given the markets' overall volatility, we'd suggest taking profits and waiting for another opportunity.
The commodity markets are made up of periods of volatility contraction and expansion. We employ our thesis by taking positions inline with the commercial trader sentiment and use their leverage to push the market our way. This is how we look for setups during periods of volatility contraction and wait for the market's internal balance to become skewed in favor of the commercial traders. Volatility expansion like the drop in the metals provides us with an opportunity to take profits. This ebb and flow of the market's dealings between the commercial traders who are tied to given market versus the large speculators is precisely what gives markets the swing trading opportunities for which we hunt. Therefore, we'll let things shakeout in the metal markets now that we've got some lead on our short positions and see where these markets come to rest.
