Gold Speculators Caused This Correction

One reason for the lack of investor selloff is the common belief that gold has begun a new bull market. This belief is actually important for where gold heads in the future, as committed investors refuse to add to what would be a manic selloff without said belief. From a historical technical perspective, last week’s selloff appears to be more a correction than a reversal.

The upward drift of gold prices this year is undeniable. The occasional violent swings we see can be accounted for by trades from three main sources, none of which are retail investors. Those sources follow:
Industry
Banks
Speculators
These three sources of gold movement can explain the sudden swings in gold prices. My hope is to explain the basics to concerned investors, allowing you to sleep easier at night. The conclusion I hope you come to is that the recent selloff does not harm a bullish thesis on gold.
Let’s start with industry. This is the group of gold purchasers who actually apply gold, such as in jewelry or electronics. For the most part, industry rides the wave: When gold is in demand, gold prices rise, and they must buy to fulfill demand regardless of the price.

Some might hedge gold, but overall the effect of industry on the price of gold is solidifying trends with increased momentum. Gold prices down and consumers not buying “investment” jewelry? Industry also reduces buying, weakening the overall upside catalyst of gold.
Banks allow gold prices to move between a support and resistance level. When gold prices look to be low, bank purchasing increases, usually at a buy limit defined by quant models. Likewise, profit taking happens when gold hits levels of resistance.
In most banks, quants – who use technical analysis – define the purchase rules for gold investments. It’s nice to think that banks are making decisions much like people – but they are not. Instead, banks act on algorithms, precluding you or I from guessing their next move, barring understanding the quant models at play.
Speculators move gold to new highs or lows. This is the group that buys gold at highs, speculating on higher highs and resistance breakthroughs. Likewise, these were the guys who shorted gold all the way down to the lows of 2015.
By watching speculators’ positions, we can see when they add to long/short positions. But how do we watch them? The options market is our best tool here.

By watching the call and put buying patterns in GLD, we can see low-risk speculation at play. Indeed, some call buying will be hedges for short positions; put buying hedges for long positions – but the majority of such purchases happens in bulk directional positions. The ratio of put/call contracts can help us not only tell which way the speculators are betting but also help us predict movements.

This is why options play a large role in earnings predictions. We can see huge spikes in call or put buying right before an earnings report. Each stock is different in how it spurs call/put buying and can be analyzed individually.
GLD allows us to do the same for gold speculators. From my analysis, I have found a number of interesting patterns. The main result is important for answering how the current gold selloff will end.

First, analyzing the overall trend of the put/call contract volume seems to be the best method for defining long-term patterns and bull/bear market strength. While it is tempting to focus on the spikes in call or put volume, the fact is that these are irrational and unprofitable bets, historically. However, had you followed the trend of the put/call ratio, you would both be right in the long-term trend in gold and would be able to predict turnarounds most of the time.
An interesting fact in this pattern is that the average put/call fell over the past few years. For example, in 2014, the put/call ratio hovered around 1.2. In 2015, it fell to 0.8, and indeed we had a turnaround, starting a bull market (possibly).

It seems like 1.0 would be the logical cutoff point. At 1.0, the ratio implies that speculators are split. The best explanation is that half believed gold had hit its true bottom and would rebound, while half were sticking with the strategy that had made them money previously: continue shorting gold regardless.
When the ratio becomes egregiously low, such as 0.3, we see corrections. At a level like 0.3, speculators have piled into the boat at unsustainable weight, and the boat must tip over, shaking some off. It usually overdoes it – moving from 0.3 to 1.5, and then back to the baseline.
This is exactly what we have seen this year. Now, the ratio hovers around 0.6, implying that bulls hold the power. While the selloff spooked speculators and brought the ratio to 1.2, that was a temporary phenomenon.
We are back at 0.6, which was the ratio that GLD hovered over during its climb from $100 to $130:

That is, the long-term trend in the GLD options market should still hold. The pullback looks to be similar to that seen in May and June, albeit “scarier” due to the size of the drop. Gold bulls have no reason to fear a return to a gold bear market at the moment, a statement that should be one of the reasons you clicked on this article, I believe.

In addition, we cannot ignore the looming catalysts for a stronger gold. Although everyone has his theory of how gold is affected by interest rates – and economic textbooks typically say something opposite – I offer this idea: a rate increase will have a bolstering effect on gold, as said increase implies a weakening economy and a need for a safehaven (other than JPY).

If the era of easy money appears to be ending, the profit-seeking phase of the business cycle could be on its way out. If so, the money flow will decrease, increasing the appeal of “set-it-and-forget-it” commodities such as gold and oil. An investor already holding such commodities or GLD at this time is positioned for becoming a millionaire.
Another bullish catalyst for gold is the election. While Clinton’s win is mainly priced in (as hers is the more likely of the two), Trump’s win could cause a quick selloff in the market and a rally in gold, if only for the uncertainty he brings to the future economic policies of the US. Indeed, the plight of the gold investor is having to pay attention to politics.

Seeking Alpha
10/10/2016