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:
- Sell to open enters in new offer
- Sell to open takes an existing bid
- Sell to close enters in a new offer
- Sell to close takes an existing bid
- Buy to open enters in a new bid
- Buy to open takes an existing offer
- Buy to close enters in a new bid
- 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.