This post is a slightly-modified excerpt from a recent TSI commentary.
The following chart shows that Commercial traders, as a group, were heavily net-long euro futures almost all of the way down (the blue bars indicate the net-position of the Commercials). Since the Commercials are reputedly the “smart money”, how could they have been so wrong?
The answer is that they weren’t wrong. Here’s why.
First, if large speculators and small traders are lumped together under a category labeled “speculators”, then the commercial net-position is simply the mathematical offset of the speculative net-position. If speculators, as a group, are net long to the tune of X contracts, then commercials, as a group, will be net short to the tune of X contracts. Second, in the currency market and also in the gold market (gold trades like a currency), speculators drive short-term price moves. This is evidenced by the fact that speculators (as a group) become increasingly ‘long’ as the price rises and then become increasingly less long, or short, as the price declines.
Due to the fact that every long position in the futures market must be associated with a short position (it’s a zero-sum game), speculators cannot increase their long exposure in the futures market unless commercials increase their short exposure by exactly the same amount. To put it another way, it would not be possible for speculators to drive the price upward by going ‘long’ if there weren’t commercials prepared to take the other side of the trade and ‘go short’, and it would not be possible for speculators to go short or liquidate their long positions unless commercials were prepared to go long or exit their short positions.
Looking at it from a different angle, it would not be possible for commercials to hedge their long exposure in the cash market by going short in the futures market unless speculators were prepared to do the opposite (go long) in the futures market, and it would not be possible for commercials to hedge their short exposure in the cash market by going long in the futures market unless speculators were prepared to do the opposite.
Both commercials and speculators are needed to establish a liquid futures market. The speculators create the opportunity for commercials to do what they do, which is to hedge by selling into strength and buying into weakness, and the commercials create the opportunity for speculators to do what they do — speculate on price direction.
That’s why the relentless complaining in some quarters about commercial short selling of gold futures and other precious-metals futures is so silly. Complaining about a large commercial net-short position is the same as complaining about a large speculative net-long position, because they are two sides of the same coin — you can’t have one without the other. Limit the extent to which the commercials can go short and you also limit the extent to which speculators can go long.
Getting back to the euro futures market, it’s not correct to say that the commercials have been wrong, because a substantial commercial net-long position in the futures market does not imply that the commercials are betting on a rising euro. In general, the commercials don’t bet on price direction; that’s what speculators do.
In the euro futures market the commercials weren’t wrong, but it’s fair to say that speculators, as a group, were very right all the way down. That’s unusual. The Commitments of Traders (COT) situation is nothing more than a sentiment indicator, and it’s rare for speculative sentiment to reach either a bullish or a bearish extreme and for the price to continue in the direction expected by speculators with almost no interruption for many months thereafter. So rare, in fact, that I can’t recall ever seeing it before.