Three Tools to Understand the Price of Gold.

(Originally published on December 2, 2016 at goldtradingmastery.wordpress.com)

If you’ve owned gold for any significant period of time, you know how volatile the price can sometimes be. One week, the price goes up a hundred dollars. The next week, it’s down two hundred.

So what causes these wild short-term fluctuations in the dollar-price of gold?

Today, I’m going to explain three tools you can use to understand the short-term fluctuations in the price of gold.

Tool #1 – The Commitment of Traders Report.

In the long-run, the price of gold is determined by the fundamentals of supply and demand. But in the short run, the fundamentals don’t really matter.

Gold is one of the most highly traded assets in the world, and the price over the very short-run is highly dependent upon the behavior of speculators and hedgers. For this reason, one of the best ways to understand the behaviour of the gold price over the short-run is to observe the behaviour of these two groups.

That’s where the Commitment of Traders Report comes in.

The Commitment of Traders Report (CoT) is a document released every Friday by the Commodities Futures Trading Commission. It lists the total number of open long and short positions from the previous Tuesday by various groups who trade futures.

The official document can be be found on this page. Just scroll down the page and click on “Metals and Other”, and then scroll down till you find the info for gold.

I find it a little hard to read the official report published by the CFTC. So I always use this page from goldseek.com and this chart from goldchartsrus.com instead.

Here’s what you need to know about the CoT report:

The Producers, Merchants, Processors and Users (or “commercials” as some people call them) are the people who actually are involved in the gold business directly. This includes gold miners, mints that produce gold coins and bars, jewelry manufacturers, etc. These people get into the futures market to hedge against the risk of the price moving against them. They’re not trying to turn a profit from speculating. They’re just trying to avoid losses.

The Managed Money group, on the other hand, is the big hedge funds, bullion banks, and other speculators with deep pockets. These people are trying to profit from predicting the movement of the price in advance. It is these people that have the biggest influence on the price in the short-run.

The commercials almost always do the opposite of the managed money. They hedge against a falling price when speculators are betting on the price going up and they hedge against a rising price when speculators are betting on the price going down.

In most cases, both sides have only a few open trades, and it’s impossible to know which one of them is right. However, sometimes the speculators make huge bets in one direction. When this happens, it almost always means that the speculators are wrong and the commercials are right.

This is because the speculators don’t actually know where supply and demand in the real world is going. They’re just using technical indicators to predict what other traders will do (just like I do in this blog on Saturdays). These indicators work over the short-run. But over months of time, they break down because they’re not based on actual sales data.

So if you ever see the speculators taking a large position in one direction and the commercials taking a large position in the opposite direction, it means there is likely to be a crash or a big rally sometime soon, depending on who is betting which way.

Here’s an example: Looking at the chart from goldchartsrus.com, you can see that the commercials (represented by the blue line) had small bets on the price falling from 2014-2015 while the non-commercials (represented by the red line) had small bets that the price would rise. But by the middle of 2016, these bets had gotten much more lopsided. This was evidence that a crash was imminent.

However, it still took another three months for the price to fall. But when it did, it fell hard. This was not because a bunch of coin collectors ran into the stores to sell their coins. It’s just because the futures traders made a bad bet.

Now that the futures traders are liquidating their positions, the market is returning to a price more in line with fundamentals.

Tool #2 – The Monetary Metals Supply And Demand Report.

So if speculators have so much of an impact on the price, how do you know what the true, fundamental price of gold is?

This is where Keith Weiner’s Monetary Metals Supply And Demand Report comes in.

Weiner is a student of the economist Antal Fekete. Fekete was the first economist to extensively study the “basis” for gold, or the rate of return a trader can get if he buys gold for immediate delivery and simultaneously sells a futures contract to swap it back for cash in the future. Weiner has taken Fekete’s theories and developed them further, and in the process has created an algorithm that determines the “fundamental price of gold”, or the price that gold would be if all gold futures contracts were eliminated.

His blog is updated every Monday morning. And it contains data from the entire previous week’s trading. Here’s an example of a recent chart from Weiner’s blog (click to enlarge). The blue line at the top of the chart represents how abundant physical gold (as opposed to paper delivery contracts) is within the Comex system. The red line indicates the scarcity of physical gold. The green line is the price of the dollar in gold milligrams.

When the green line goes up in tandem with the red line (and when the blue line moves in the opposite direction) it means that speculators are causing a shortage of gold in the Comex system as they sell their gold contracts. In other words, it means that traders are fighting against the “real” market, trying to push the price of gold down below its fundamentals. This is unsustainable and is likely to be reversed before long. On the other hand, if the green line moves up without affecting the red and blue lines (as it does in this particular chart), it means that traders previously made a bad bet and are now selling their contracts to move the price back in line with its fundamentals.

This can also be used to determine whether a move up in the gold price is “real” or not. If the green line moves down in tandem with the blue line, it means that speculators are buying paper contracts and causing the real, physical metal to build up a surplus in the Comex system. This is unsustainable and will likely cause a crash at some point in the future. If the green line moves down without affecting the blue and red lines, it means that the price of gold is moving up due to fundamentals, not because of errors on the part of speculators.

It’s important to understand that this indicator should not be used by itself to initiate trades. Sometimes traders push up the speculative price above its fundamentals, but then later on the fundamentals themselves move up to the speculative price. In other words, sometimes speculators correctly anticipate movements in the fundamentals ahead of time. This is especially likely to happen in cases where the difference between the fundamental and speculative price is small. So this tool has to be used in conjunction with others to determine whether there truly is a discrepancy between the spot price and the fundamentals or whether it’s just giving a fake signal.

Keith Weiner’s blog can be found here.

Tool #3 – The World Gold Council Gold Demand Trends Report.

Every quarter, the World Gold Council gives a report on the latest trends in the gold industry. This Gold Demand Trends Report is filled with invaluable information that can be used to explain the long-term course of the gold-price.

For example, here is some of the data you can find in the latest report:

demand-trends-report-image

This table states that 493.1 tons of new gold was sold in the form of jewelry in Q3 2016, 82.4 tons in the form of technology, and 190.1 tons in the form of gold bullion bars or coins. In addition, central banks bought 81.7 tons of gold to use as currency reserves and gold-backed ETFs bought 145.6 tons.

This report gets even more interesting when you compare it to the supply report, the latest of which can be found here.

If you take the supply brought onto the market through recycling (which is really negative demand, since it’s part of the aboveground gold stock) and subtract it from the total physical demand, you get the “net demand” for physical gold. If you then add this subtotal to ETF and central bank purchases, you get the total net demand for new gold. Once you have this total, subtracting mining output gives you the net new demand over and above what is supplied by mining output. I won’t bore you with the mathematical details. But what you find out is that the demand from new gold buyers outstripped mining supply in the first quarter of this year, but fell in the second and third quarters at the same time that mining supply expanded. This goes a long way towards explaining why the price of gold has been so volatile this year.

If you’ve owned gold for a while, it’s normal to feel frustrated by the wild swings in its price. But using these three tools should help to make the price more comprehensible and less aggravating.