The Gold Futures Open Interest Caper: Part 2

Regular readers will know that most traders with a short position in the futures market are not “naked”. It is an easy trap to fall into, to assume that everyone else in the market is the same as the small trader: betting on the likely direction of price. But, this is not the case.

The futures markets exist to allow producers to lock in a known profit, and to assure those who finance them that they can operate for the year with enough revenues known to cover fixed costs and debt service. On the other side, consumers want to lock in a supply of critical inputs at a known price.

Into this idyllic and simple little world enter the speculators. They read the weather forecast, the Dept. of Agriculture planting reports and anything else to help them figure out the likely direction of the price.

There is one other important player, but he is misunderstood. The warehouseman is in business to carry commodities. He does not buy with the hope of a price increase. He simultaneously buys the physical commodity in the spot market and sells a future against it. He is in business to make the spread called the basis. This is why basis is defined as Future(bid) – Spot(ask). The warehouseman must pay the ask in the spot market and accept the bid in the futures market. If this spread is greater than his cost (i.e. storage plus interest) he can put on this trade.

If the spread inverts, the warehouseman can decarry: sell the physical good and buy the future. This is possible when the cobasis is positive = Spot(bid) – Future(ask). A decarry will unwind a carry (decarrying is also possible for anyone who owns the physical good outright).

Leaving aside that in a free market (i.e. gold standard), there would be no such thing as a futures market in gold, today there are many players who carry gold. Gold will often have a basis of 0.6% or higher. Thanks to Bernanke’s interest rate suppression scheme, 0.6% would be pretty attractive right about now.

It is in this light that I say that most shorts in the market are not “naked” but arbitraged; they are carrying gold. How does this help us understand the open interest numbers?

With one condition, there is something we can say about the gold arbitragers with confidence. If the basis is above a threshold and rising, they will be adding to their position. Whatever attractiveness the gold carry trade had at 0.5% basis will be increased if the basis rises to 0.51%. If the basis is falling, which typically means the cobasis is rising, and especially if the cobasis is positive, we can say that the gold arbitragers will be decarrying gold.

The one condition is that the arbitragers need credit. If there is a problem in the credit markets, then they may not carry when there is an opportunity (they could even be forced to decarry a lot of inventory in a hurry if they must shrink their balance sheets).

In reality, it is more complex than this, but the take-away is that arbitragers increase and decrease their positions based on changes in spread. They do not care about changes in price, as they have no exposure to price.

This segues into another important point. There is always a buyer to every seller and a seller to every buyer and CME (the operator of the COMEX market) acts as the counterparty to everyone.

While the details of the algorithm that matches buyers and sellers, and creates and destroys contracts are proprietary to CME, we can look at this problem as a generic problem in computer science (I was a software developer in a previous career). Let’s start from scratch: a new contract opens for trading. Initial open interest is 0. What happens next?

Someone enters in a bid, indicating how much he is willing to pay and how many contracts he would like to buy. Another trader may sell on this bid, or may enter an offer indicating price to sell and number of contracts. If others come in with higher bids than the initial and lower offers than the initial, there is still no transaction that can clear.

As soon a new buyer takes the best offer, then there is a transaction. Now the exchange must create the number of contracts bought by the buyer. The buyer is assigned a long position and the seller is assigned a short position.

Next, a new seller wants to accept the best bid. If this bid is from the trader who is short from the first transaction (and the quantity is the same) then no new contract will be created. The short side of the first contract will be assigned from the first trader to the second. Otherwise, new contracts must be created.

Eventually, a sizeable number of contracts are open. But it is important to note that they can trade hands many times without an increase or decrease in the number of them. If they are trading because buyers are accepting the offer, then the price will be rising. If they trade because sellers are taking the bid, then the price will be falling.

There are 8 cases that the algorithm must handle:

  1. Sell to open enters in new offer
  2. Sell to open takes an existing bid
  3. Sell to close enters in a new offer
  4. Sell to close takes an existing bid
  5. Buy to open enters in a new bid
  6. Buy to open takes an existing offer
  7. Buy to close enters in a new bid
  8. Buy to close takes an existing offer

By going through each of these 8 cases one could begin to design the algorithm that is inside the exchange (it would get complex, even more so if the algorithm could wait and do a “look-ahead”).

The take-away here is that there is no particular correlation between “rally” and rising open interest or between “crash” and falling open interest. As discussed above, the majority of the shorts are arbitragers who care about spreads and not prices. They may not be buying or selling as price rises or falls.

As discussed here, the exchange has an algorithm to create and destroy contracts that has a lot more complexity to it than one would think. Even if traders are furiously selling, it could be that one long is selling to another who then sells to another, without the exchange having to create or destroy a contract.

Assuming that there is always a bid and an offer (which is the case for gold or else we would have REALLY big problems), a new long could be bought from an existing long who is closing his position, or equally from a new short, who is opening his position.

There is a lot more to analyze about the open interest in recent weeks, but we will have to save that for a future article. But hopefully the reader can see that the conspiracy theory of the “bankster cartel” selling futures naked in order to suppress the price is purely a figment of Gold Bug Man’s imagination.

7 replies
  1. allenching says:

    1) You need to come up with the cost of carry (interest + storage + insurance) before judging the 0.6% pa is attractive or not.

    2) If “the majority of the shorts are arbitragers” is true, that means warehousemen are already carrying gold and short futures. If so many arbitrage trades have already been put on, any arbitrage opportunity in normal contango should have been eliminated already.

    3) to deduce “the majority of the shorts are arbitragers”, you need to prove the basis should have been higher (i.e. 1%pa) if not arbitragers putting on their arbitrage (carrying metals). The static state of basis =0.6% pa does not support “the majority of the shorts are arbitragers”.

    4) On the other side of the trade, who is the majority of the longs?

    Thanks for answering my questions.

  2. happel says:

    While you have managed to dissuade me from believing in the gold-bug theory of manipulation, I did find this of interest:

    One thing I have noticed about the non-fiat beholders of gold, other PMs & things like Bitcoin. All rational conversation against them are met with fierce, religious-like conviction and there is little chance of persuading them of believing otherwise.

    I do not believe central planning, especially that of the likes of the Fed are eventually doomed, it is always best to keep an open mind. Thanks again for the educational piece, Keith.

  3. Keith Weiner says:

    Thanks for your comments.

    allen: You make an interesting point. At any given time, the arbitrage is done to the point where the marginal arbitrager walks away. This could be due to opportunity cost–there is something else more interesting available in the market. Or it could be because the basis is barely over carrying cost. But the basis can change every day and not necessarily due to the actions of the arbitragers.

  4. gkcpoptopg says:

    I notice from the current and prior periods covered by the last two COT reports for Comex gold (that is, data for the period ending on April 16, and for the period ending on April 23) that there were disproportionally HUGE jumps in the “Commercial Traders” open interest numbers for “combined futures and options positions.” For the period ending on April 16, combined futures and options positions jumped 69,827 contracts for the longs, and 55,213 contracts for the shorts. The parallel data for the “futures only positions” showed increases within the bounds of normalcy — up only 8,667 contracts for the commercial longs, and only 6,794 contracts for the commercial shorts. The data released Friday for the period ending April 23 showed a further increase in the commercial long, “combined futures and options positions,” of another 17,210 contracts, while the commercial short “combined futures and options positions” actually declined by 19,368 contracts, still leaving most of the April 16 increase on the board. We all know that the commercials can mix-and-match options with futures in ways we speculators cannot, but what do you think of the tremendous increase in options activity over the past couple of weeks? I agree with you that the large speculators act, while the commercials RE-act by adjusting eternally open books, and that there are no “bankster” conspiracies. Without the commercials being there to take on all speculators, there would be no gold market as we know it. But what’s your take on the sudden increase in options activity among the commercial traders, relative to speculators, during these past 2 weeks of violent price swings?

    Thank you.

  5. steevan16 says:

    Hello Dr.Keith,

    I came across your work in serendipity especially after watching Prof.Fekete on the Kaiser Report about a week ago and have been reading many of your papers/articles since –really fascinating I must admit. I have also watched your presentations on the irredeemable paper currency videos twice so far and it’s slowly sinking in now. Your school of thought has given me a whole new perspective into this on-going economic crisis and has made me realise that a strong theoretical foundation is essential to understand a phenomenon. So far I was randomly going through the content on the internet to get an idea as to what was going on. There is so much of variety of reasoning and the associated misinformation (even from the Austrian/Gold based theory proponents) it is difficult to weed out chaff from the wheat to an uninitiated on the matter. Owing to this, the mind simply can’t form a consistent opinion on the subject unlike science for example. The “gold bug syndrome” indeed played its role in clouding my judgement all along. Due to the fact that gold and silver has not reacted in the last 12 months to any of the predictions even from the most experienced “experts” in the field I was sort of wandering aimlessly, doubting everything. In fact, with my unquestionable faith in them I ended up buying a sizeable portion of precious metals (not using leverage though, fortunately) but the events played out between April 12-20 almost shook my confidence and reached a stage where I nearly stopped believing anything anyone had to say on the matter. It looked like nobody had a clue as to what was going on. But now, after reading on the New Austrian theory it has explained a lot in this area and has taught me what to expect in the future and how to react (At least I think I do). Now I tend to look at Gold less in terms of dollars ( but it’s a bit difficult to stop being a gold bug man though!). It really takes some mental effort to get around to the idea that Gold is not a speculation hedge in the strictest sense instead it should be treated as an inflation hedge, an insurance or for that matter a means during transitions between the monetary regimes to carry over the wealth.

    Now I am at a stage where I think I feel confident with your explanations but I still have a few questions. Hope you will be able to answer them. Please take your time in responding.

    1. You mentioned that the Fed printing money does not necessarily relate to the proportional increase in gold price. At the same time you also mentioned that the new counterfeit credit has not created inflation in the economy (QE1…n). In that case where has that counterfeit money gone? If it’s stuck in the banking system (i.e. hasn’t entered the general economy yet) then what’s it doing wherever it currently is? Are the bankers who have access to it doing anything with it at all? Has that money escaped into the stock market as Dow seems to be doing well?

    2. You mentioned about the over-abundance of gold above ground which is maintaining the price (1:80 stock to supply). But in the last 2-3 weeks all we are hearing about is more and more buying in retail, be it Thailand, China, India or even Eagles in the US for that matter. My question is if everyone is buying, then who in your opinion is selling for there to be so much of gold. My point is, who is willing to part with their physical gold in this uncertain economic climate for the price to remain low and everyone knows the system is crumbling? Or is it that the things are not as bad as they are being portrayed?

    3. Slightly related to the question above, if there is 1:80 stock to supply do you think price can fall below $1000/Oz (say to $300/Oz where it was for a long time before 2000) even when the reported mining cost is upwards of $1000/Oz?

    4. Do you believe in the circulating rumour about the Central bank gold vaults being empty as they might have secretly sold/leased the gold? Cases such as ABN Amro settling in cash with customers do add certain credence to this matter. Clearly, the annual gold production (1200 tonnes?) may not be fulfilling the growing global demands so the gold has to come from somewhere. If the Central banks vaults are indeed empty and they suddenly admit it (unexpectedly), would your gold basis report cover such a scenario to anticipate a situation where the gold is going to continue its bull ride? My point is, how reliably the basis report can anticipate such sudden moves?

    4. On April 12th and 15th, there were wide-spread reports of 500 to 600 tonnes worth of paper gold being dumped on the market which triggered the crash (even Zero Hedge reported it). What’s your opinion as to the veracity of this claim? Apparently there was an unusual meeting of the top bankers just before the 12th crash with the POTUS and the “experts” were referring it as a fuse to the next leg of the crisis.

    5. If you wanted to buy 10 ounces of gold would you buy it now or wait further to see if there is another correction?

    6. Contrary to what many of the doom experts have been saying for some time now, in your presentations you also mention that there cannot be hyperinflation as the Fed just can’t print money as legally they have to have a collateral (public/private debt) before they can start the printing presses. Given how powerful the Fed is, in desperate times why can’t they change the law so that the government gives permission to the Fed to print without collateral to fulfil all debt obligations which would lead to hyperinflation? Isn’t that what Greenspan said to the Treasury Select committee back in 2005/06 that they have the power of the press to fulfil any debt obligations? In that case wouldn’t hyperinflation be a possibility?

    6. I am originally from India but now settled in the West. I have a few questions about the Indian government adopting the gold standard in the eventuality that the Dollar stops being the reserve currency.

    As per official reports the Indian government has about 550 tonnes of gold which is much lesser than the amount of credit/counterfeit credit/money in circulation given the current “price” of gold. In that case, without there being a drastic revaluation of gold in Rupee terms what options do you think India has going back to the gold standard? As per “some” estimates Indian households have more than 20000 tonnes of gold most of which is in the public sector bank safe-lockers ( I know this because everyone does that in India – nobody keeps gold at home for safety reasons apart from the women keeping the bare minimum which they want to wear on a daily basis). In this case do you think, in a desperate measure during an apocalyptic scenario, the Indian government will confiscate gold so that it can go back to the gold backed currency just like how FDR did in the 30’s? My main question is, is it a must that the government should have enough convertible gold in order to go back to the gold backed currency? If that does happen in India I personally do foresee blood on the streets but I would like your opinion on this matter as to how things might play out.

    The banking system in India seems to be marginally better compared to those in the West but a lot of them are suffering from non-performing assets (mal-investment). Most of the big banks in India are government-owned (since early 1970’s) but I do not get a picture as to how the government would react in the case of emergency. Somebody has to take a hit somewhere as there is no magic bullet in the economy based on counterfeit credit. Official inflation rate is between 8-10% and the interest rates are closely following it. But I read about the G20 G-SIFI directive from late last year where the countries have mutually agreed to confiscate depositors’ money to bail out the banks in trouble as opposed to dumping the onus on the tax payer. Cyprus has set the precedent and the people in charge are tacitly acknowledging it to be the solution when the next crisis hits to Europe/US/Canada. Do you think the other G20 countries (Asian) will use G-SIFI as an excuse to steal depositors’ money to recapitalise the troubled banks? I appreciate that you might not have enough knowledge on the Asian banking but just wanted to your gut feeling. Feel free not to answer if you are unsure.

    7. If I were to do further studies on the New Austrian Economics what would be the best option? Is there any official courseware, university etc. for distance learning? Would purchasing the Austrian school courseware from be recommended in your opinion as a start? I know your school slightly differs from them when it comes to Fractional Reserve Banking and the Real Bills doctrine.

    Thank in advance for taking time to go through my lengthy email.


    Steve D’Souza

  6. FreedomLover says:

    I am not attempting to answer for Keith, but here are some comments:
    1. There are sound economic laws, there are mistakes attempting to explain economic laws, and there is economic alchemy, i.e, intentional misinformation. It is important not to confuse these. Economics is a science just as much as physics is. However, it is not a quantitative science. There are no economic constants and no economic equalities. If you see an equals sign, it is not economics, but something else, accounting, finance, or economic alchemy.
    2. People make mistakes. However, Austrian Economics as it is known represents the bulk of all advances in economics in the late 19th and entire 20th century. Dr. Fekete and Keith base much of their work on the work of Menger, von Mises, et al. It is normal for some errors to be introduced as one advances a science. These errors are corrected by those who carry the torch next.
    3. There is nothing about Austrian economics that advocates gold per se. What economics (including Austrian economics) can demonstrate is that economic freedom leads to superior outcomes compared with economic coercion, to any degree. Anyone advocating gold (as opposed to a free monetary market) is either assuming Gold will be chosen by the free market (a fair assumption and I believe Keith holds this view) or is advocating coercion (though perhaps a reduction from our current position), and thus a suboptimal outcome.

    • steevan16 says:

      Thank you FreedomLover. Much appreciated.

      My intention is to gain a sufficient level of knowledge to understand all the intricacies of the modern finance so that I can start evangelizing to those who haven’t got a clue as to what’s happening around us. In my opinion that’s 99.99% of the people that I know. By the looks of it most of them have unconditional faith in their governments.

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