TED BUTLER COMMENTARY     

October 16, 2007

Rope-A-Dope?

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

By now, even casual observers of the Commitment of Traders Report (COT) are aware that we are at record extremes in the COMEX gold futures market, with new records occurring almost daily. The net long position of the large non-commercials and the net short position of the dealers appear to have reached epic proportions.

In the past two months, from the price lows in August, and extrapolating through today, 150,000 contracts (the equivalent of 15 million ounces) have been added to the commercial net short position, and now stands close to 250,000 gold futures contracts. Arrayed against the commercials are primarily the non-commercials who have bought and added close to the same net 150,000 contracts (the smaller non-reporting traders make up a small portion of the added net long side amount, around 10%).

As I have written recently, it is this non-commercial buying, by tech funds and other price momentum type traders, that primarily accounts for the $100+ price surge in gold over the past two months. I am aware of no gold buying force greater than the 15 million ounces bought (and sold) on the COMEX. Never before has this many COMEX gold futures contracts been created in such a short period of time.

It is also my opinion that the resolution of the recently added 150,000 gold contracts will determine the near term direction in gold (and silver) prices. Because the size of the added and total position is so large, it is hard to imagine how this resolution can be affected without a large measure of price violence. The only question is the timing and direction of the price volatility. Viewed as a game of poker (a fitting analogy) the pot has grown to historic proportions. And while the pot can grow larger, as and if gold moves higher and more longs and shorts are put on, ultimately it comes down, as it always does, to who is going to blink first and fold.

In the past, in similar market structure set ups, it has always been the non-commercial technical traders who have blinked and folded first on eventually declining prices, allowing the commercials to buy back at lower prices than achieved in the prior moves. This is what created the risk of a sell off in the past and creates currently. It goes without sayimg that the larger the long and short position, the larger the potential risk.

Sometimes, the technical traders get out at break-even levels, or even small profits, if the price of gold or silver has climbed and remained at high enough prices long enough to allow the moving average close-out signals to permit this. Other times, the tech funds liquidate at significant losses, if their close out points are much lower than the average price at which they bought. I don’t recall the tech funds, as a group, ever liquidating a large gold or silver long position at a large profit.

Conversely, the commercials have never bought back or closed out a large short position at a large loss, even though they have held such open short positions with very large unrealized losses on many occasions in the past. Somehow, the commercials have always waited it out if the market was against them and were able to eventually close out short positions on more favorable price terms. Of course, past history is no guarantee of future events, and it is possible for the commercials to lose big on their current extremely large and losing gold short position.

My point is that this is all a very much-unresolved issue. Remember, we are talking about open interest, with the operative word being open. We will be able to explain the resolution only when this open interest is closed out. Until then, we must rely on facts, history, and current circumstances and base our speculation on that.

Against what must be a considered a COT structure that screams warnings of a sell-off, we have a gold background environment and chart structure that has rarely been as positive as it is currently. It is this dichotomy between the COT structure and conventional analysis that sets the stage for possible fireworks.

Can the commercials be over run and forced to buy back their short positions at great losses? Absolutely, although that has never happened. If the dealers are forced to cover as a group, the gains in the gold market will prove to be a heck of a lot more dramatic than we have seen to date, as the sellers of last resort are removed from their price-capping role.

Can the game continue with the pot growing as more technical traders plow into the market and the commercials continue to sell short? Sure, but that would only serve to delay the day of reckoning and promise it has an even more dramatic resolution.

This is just my speculation, but I still lean towards the third possible outcome, in which the dealers manage to engineer a sell-off, at least below the key 50 day moving average. This is the "normal" outcome. It is pure manipulation and an outcome I don’t necessarily favor, but it is the outcome we have seen in the past.

I get the feeling that the commercials may be employing the rope-a-dope. This is the strategy employed by the legendary boxer, Muhammad Ali, http://en.wikipedia.org/wiki/Rope-a-dope, in which he would let the other boxer punch himself out and grow tired before attacking. My sense is that the dealers may have allowed the tech funds appear to have run roughshod over them, as the funds establish increased positions at ever increasing prices and ever increasing unrealized profits.

While it is true that the dealers are now sitting with about the largest unrealized paper loss in memory in the gold market, they have also been increasing the average collective price on their shorts and may not be in as bad a position as it may appear. Yes, the dealers total open loss on the 150,000 contracts added since mid-August now runs about $500 million, but that is just over $30 per ounce.

If the dealers are still in control, they can rig the price to recoup the open $30 open loss without much difficulty, and then some. If there are forces that will cause the dealers to be over run this time, the $30 per ounce open loss will blossom into a loss of much greater significance. Time will tell who has the upper hand.

My concern for silver is still that the dealers may use a sell-off in the gold market to rig a sell-off in silver. One of the long term encouraging developments in silver is that the dealers appear very reluctant, up until now, to allow silver to run up in price like gold. If silver had been stronger price-wise (easy for the rope-a-dope dealers to arrange), it would have undoubtedly encouraged more tech fund buying and necessitated more dealer short selling. I get the feeling the dealers, particularly the concentrated shorts, don’t want to greatly expand new short selling in silver above the amounts expended so far. I think this could be true for a number of reasons, including too much publicity lately on the concentration issue, or something they see developing in the physical silver market. Neither of these possible developments, obviously, would be long-term bearish.