The best time to trade against hedge funds

I will update the gold picture this morning, because the market has provided a stark illustration of what happens when hedge funds get it wrong – and they do that quite often.

Hedge funds are among the biggest players in the market, so we need to keep track of their activities. As I have pointed out, they are largely trend-followers. They are momentum traders and use trading programmes that track the momentum of the market.

And because they trade in huge quantities, they are not as nimble as small traders. This means that it takes much longer for the hedgies to change tack – and that’s one reason they are often wrong at market turns. So today I’ll tell you how investors can benefit from their mistakes.

Why small traders love a good story

One of the best times to take advantage of the hedge funds is when a story can be built around a particular bullish or bearish stance.

Why? Because small traders just love a good story! And this group can enhance market moves. In December, they had fallen in love with the ‘gold is bad’ story. Sentiment measures were pointing to record low levels of bearishness, with the Daily Sentiment Index (DSI) reaching an extreme low at the 5% level at one point.

There were widespread forecasts of sub-$1,000 gold.

Then in January, the market started turning up and sentiment turned with it.

I used this information to position on the long side of the market. The oversold condition was correcting as a new gold story was finding favour (gold is good). This new story was based on the heightened Ukraine conflict and reports that China was buying physical metal in volume.

The hedge funds were at the fore in predicting $1,400 gold, which was my original target in early January.

And as the market approached this target, DSI readings had reached an extreme 85% bullish level.

But as I wrote, this target was missed (as I forecast) and in just ten days, the market fell $100 to last week’s low of $1,285.

How to know what hedge funds are doing

Luckily, we don’t have to guess what hedge funds are up to – we have the commitments of traders (COT) data.

In my 24 March post, the market was declining off the $1,388 high where the COT data was showing that the hedge funds had built up a four-to-one bullish position.

Here is the latest COT data which refers to the 25 March picture:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
(Contracts of 100 Troy ounces) Open interest: 398,264
Commitments
169,083 51,766 30,361 159,979 287,600 359,423 369,727 38,841 28,537
Changes from 03/18/14 (Change in open interest: -22,362)
-14,241 5,256 -2,338 -4,314 -22,627 -20,893 -19,709 -1,469 -2,653
Percent of open in terest for each category of traders
42.5 13.0 7.6 40.2 72.2 90.2 92.8 9.8 7.2
Number of traders in each category (Total traders: 280)
124 75 73 51 58 212 177

 

The non-commercials (largely hedge funds) sold a large chunk of their longs and increased their shorts last week. That means they now hold only three longs to one short.

But has this driven out the froth so that the market can stage a rally?

Will the gold support hold?

This was the chart I had last time:

Gold price spread betting chart

If the larger trend was still up, then I expect the decline to have an A-B-C form.

And if an A-B-C did form, a positive-momentum divergence would add strength to the ongoing rally case.

This is the updated chart this morning:

Gold price spread betting chart

Since last time, the market has declined on cue – and precisely to the meeting of the tramline and the Fibonacci 50% level, where the decline has retraced 50% of the entire rally off the 31 December low.

Remember, the 50% level is a common retracement if the main trend is still intact. Also, if my tramlines are still working, there should be a kiss on it before the uptrend resumes.

And the positive-momentum divergence I had suggested last time has appeared (red bar).

Gold is starting to look interesting

One other piece of information: At last week’s low, wave C equals wave A in height. Remember, another common relationship in an A-B-C corrective pattern is the equality of the A and C waves. This is significant.

So it appears the odds are building up for a bounce from near current levels if my C wave has ended.

Not only that, but the latest DSI readings have fallen sharply off the bullish extremes of two weeks ago.

This is starting to look interesting!

 

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