Hedgies and highwaymen – how to steal from the rich

John C Burford explains how hedge funds often find themselves on the wrong side of a trend, and how traders can profit from this phenomenon.

Traders often have to disagree with an overwhelming majority opinion on a market. And for some, that is an extremely difficult attitude to take. The vast majority of us are hardwired to find a group to join, and feel very uncomfortable when we're outsiders. It is like being naked we crave the comfort blanket provided by the group.

That is why most traders read only pieces that conform to their own beliefs they want the warm glow of comfort that comes with agreeing with someone prominent. A deep desire to follow a leader is another very human characteristic.

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Personally, I have always distrusted leaders and consequently groups of all kinds. That has stood me in good stead in when it comes to trading, as my methods exploit trend changes.

When a market changes trend, the vast majority are on the wrong side of that change. It has to be that way, of course. During the trend, more are drawn to it as even the most unaware will finally recognise that there is a trend there.

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The trend is your friend, remember?

In a bear trend, powerful selling by the bears and the disappointed bulls drives the trend down.

It is a curious fact that hedge funds (who dominate speculative trading in some markets) are mostly trend-followers. They are not the hip-shooting mavericks of popular myth, picking tops and bottoms at random.

Basically, they are a classic group, all using the same algorithm models for their trading decisions, acting in concert most of the time. Going against the herd is not a career-enhancing option.

That means that as a group, hedge funds are usually caught on the wrong side of major market turns. That is a very useful fact that we independent traders can exploit and one that gives me enormous pleasure (hey I am human!).

How do we know when hedge funds have piled onto one side of the boat?

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There are two main data sources I follow: the commitments of traders (COT) data and sentiment surveys.

How is the market trading gold?

Non-commercialCommercialTotalNon-reportable positions
longshortspreadslongshortlongshortlongshort
Contracts of 100 Troy ouncesOpen interest: 406,069
Commitments
186,813111,72333,742150,277228,866370,832374,33135,23731,738
Changes from 02/06/15 (Change in open interest: 7,345)
-7,48621,83494411,854-17,7075,3125,0712,0332,274
Percent of open in terest for each category of traders
46.027.58.337.056.491.392.28.77.8
Number of traders in each category (Total traders: 327)
129102715451220195

The hedge funds (non-commercials) hold many more futures than the small specs (non-reportables). The period from mid-May to 9 June saw the market decline as the hedgies increased their short holdings by over 20% and reduced their long positions by about 4% a massive swing of around 25%.

That is trend-following with a vengeance!

When the inevitable upturn arrives, the rally will very probably be sharp as the shorts find themselves in a squeeze.

Incidentally, for most of history, specs have been heavily long gold and the commercials (principally the miners) are hedging and necessarily short. To see a situation where there is an approximate balance between long and short is unusual and tells me that the specs are unusually bearish and the commercials are unusually bullish. Remember, it is the commercials that are considered the smart' money. Hmm.

Where have all the gold bulls gone?

But why had everyone suddenly fallen out of love with gold? Many reasons' were cited, including the prospect of higher US interest rates, the relative attractiveness of equities and the booming US dollar. But in reality, bullish expectations had been pumped up between November 2014 and January 2015 as the euro was falling out of bed.

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So what has the market's reaction been to this state of extreme bearishness? Naturally a trend change! The big clue was the momentum divergence on the hourly chart at the low.

150619-MWT01

Since March, the market has been in a huge consolidation phase with no clear direction apparent. Note that every new low or new high was quickly reversed. If trading breakouts, you would have been whipsawed to death and that is why I rarely trade breakouts in gold except to fade them.

If this is the start of a third wave, I expect the hedgies to gradually switch out of shorts and into longs as their algorithm models tell them. But as independent traders, we can get a jump on them. As they revert to the bullish side of the boat, we will prepare to abandon ship and even consider a short trade at a high as they inevitably will be on the wrong side of the market again.

Perhaps this trading style is one reason hedge funds generally underperform, with their investors wondering why they are paying them 2% management fee and 20% of gains.

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