In Ted Butler's Archive

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COT Extremes

(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.)

It’s been a while since I have commented in detail about the Commitment of Traders Report (COT), since there have been other issues to be discussed. Plus, I know many find the topic confusing. However, there have been some recent developments that should be reviewed.

Long-time readers know that I have studied and written about the COTs for years. I find the report invaluable. This weekly report from the CFTC tells us who has been buying or selling in all U.S. futures and options on futures. The reports don’t tell us the “who” by name, but offer three broad trader categories – large commercial, large non-commercial, and non-reportable. The two large categories must report their positions to the CFTC on essentially a daily basis, once a minimum contract size has been achieved. The data for the non-reportable category is calculated on an “all other” basis by deducting all the reportable traders’ positions from total open interest.

Speaking specifically about the COMEX silver and gold markets, the non-commercials are comprised of large speculators, including certain hedge funds that trade futures contracts on a technical price basis (tech funds). The commercial category is mostly comprised of financial institutions (banks who are speculating). Many people assume the commercial category is mostly comprised of large producers and consumers of gold and silver engaged in legitimate hedging. That’s the way it probably should be, but in my experience that is generally not the case. The non-reportable category is comprised of all traders, speculators and hedgers alike, who fall below the threshold contract reporting limit (150 contracts in silver and 200 contracts in gold)

The purpose of studying the COTs is to try to determine if the market is structured to move big, either up or down in price. This is done by trying to gauge those points at which the individual categories are at such historical extremes, either to the long side or short side, that they are likely to reverse. As a general rule of thumb, the non-commercial and non-reported categories are pitted against the commercial category. In simple terms, when the non-commercials and non-reportable are extremely long and the commercials are extremely short, a big sell-off is likely. When the non-commercials and non-reportable categories are at very low levels of long positions and the commercials are at historical low short levels, a large price rally is likely.

This method of gauging the COTs has proven very reliable over the years, although it is far from perfect. In fact, this measurement has been particularly weak in gauging the extent of the recent large decline in silver and gold. For instance, the COTs started flashing “buy” in silver at $16 in August, even though the price eventually declined below $9. This raises the legitimate question that if an indicator can miss by so much, should it still be relied upon? To me, that’s like asking if democracy is the best form of government. First tell me what’s the alternative?

The question of the legitimacy of the COT analysis derives from the almost stubborn nature of the indicator itself, namely, it is a “do or die” indicator. If the COT flashes “buy” it will not flash “sell” until the structure of the holdings in the categories changes to an extreme in the other direction. In this sense, the COT approach is not price generated, but structure generated. What this means is that the COT approach can be “wrong” in terms of price, while not wrong in terms of structure. In other words, it can sometimes fail to tell us of the exact bottom or top in price by wide amounts in time and price. Like indicating a buy at $16, and all the way down to $9. (The only way to offset this inherent weakness in the COT is by controlling what and how we buy – real metal, for cash, not margin).

The market structure for silver and gold have been flashing buy for months. All the way down. In fact, the COTs in gold and silver are more bullish now, in many important sub-categories, than they have been in years. With that background, what are the new developments in the COTs that I opened this article with? Let me give you the conclusion up front – I am shocked with the extent to which the big shorts have gone to liquidate every possible long silver and gold position held by traders in the non-commercials and non-reportable categories.

In fact, the big shorts have even managed to recently liquidate some big long silver positions by other commercials (the raptors), held in the form of long silver/short gold spread positions. About a month ago, I noticed an unusual liquidation of raptor long silver positions over a two week period, in the amount of around 8,000 contracts (40 million ounces). What made it unusual was that I had never seen the raptors (the smaller traders in the commercial category, other than the 8 largest) liquidate long positions on a decline in price. For a while, I couldn’t figure out why many different traders would liquidate positions held for a long time so suddenly. Then it dawned on me (in a conversation with Izzy) that it had to be silver/gold spread liquidation brought about by changes in margin and/or margin collateral requirements. These changes were dictated by the big shorts themselves, who undoubtedly cleared the accounts for the raptors. For the first time, the raptors were forced by the big shorts (read JP Morgan) to liquidate long silver/short gold spread positions. Talk about a clean-out of silver long positions.

The most recent COT report, as of the close of business November 25, indicated another shocking liquidation of long silver/short gold spreads, this time by those held in the non-commercial category. Roughly 15 different non-commercial traders suddenly liquidated at least 5,000 additional long silver/short gold spreads. I would submit that the only way you could get 15 separate accounts to act in unison would be if you forced them to act. And just like the earlier forced liquidation of raptor spread positions, the only way you could force them was by radically altering margin collateral requirements. Who decides to radically alter margin collateral requirements is the prime broker who holds and clears (guarantees) the accounts (read JP Morgan).

What this means is that new and unprecedented efforts have been made to forcibly liquidate the long silver holdings of any account not held by the big shorts. Those shorts are resorting to tricks never employed before. The COTs were already wildly bullish before this blatant silver/gold spread forced liquidation. What comes after wildly bullish? All this should make you think. Why is the big short so intent on liquidating every long position he does not hold? The answer should be clear. Because he knows the real story in silver, and that the price will soon reflect that reality. He is determined to buy as much silver as possible, through any means available. So should you. The fact that the big short is forcing as much silver liquidation as possible, should harden your resolve to own silver.

* * * * * * * * * *

As I was finishing this article, I received an e-mail form letter from the CFTC concerning the silver manipulation they are supposedly conducting. Others of you have sent me copies of the same e-mail form letter. The CFTC sends me, for the very first time, a form letter asking for information about a manipulation in silver after me contacting them on many hundreds of different occasions over the past 23 years. Are they kidding? I don’t know whether to laugh or cry.

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