We are periodically reminded just how small the gold market still is like we were this past week when the hedge fund SHK Asset Management folded. Of course it’s a good thing that the gold market is still so small because moderate inflows of capital can and will continue to make a meaningful impact on the gold price. At some point the gold market will be much bigger and then moderate capital flows will not matter so much.
But for now, a professional poker player like Daniel Shak can start a hedge fund that only trades spreads in COMEX gold futures, go on to lose 70% of his clients’ money, and then decide to nonchalantly close the hedge fund on a single day during which his antics result in a decline of COMEX futures open interest by a massive 80,000 contracts (14% of the market). Here is what he said about it:
“Yeah, that was just me liquidating my spread position,” Shak told The Wall Street Journal. “I had a significant, fully-margined position. The dollar amount of the gold liquidation was very small, it was just a lot of contracts.”
Typical poker player “cool” attitude! How somebody can manage to lose 70% of an account in spread trades with COMEX gold futures — where you are short one month and long another month — is beyond us but perhaps this gambler was biased in favor of either backwardation or contango and instead his spreads went the other way. Backwardation as you may recall is the condition where further-dated contract months are trading at a lower price compared to the spot month. Contango is where prices are higher in the far-out future compared to the spot month. Because gold incurs storage and insurance costs and does not generate a return in the form of interest, it is normally in contango, which is also known as cost to carry (in reference to holding a physical position).
In any case, this Shak character might have decided that the gold market was in for a squeeze with the probable result being backwardation or at least a shrinking in contango. Maybe he read a bit too much GATA or Zero Hedge. Maybe he thought the gold basis can be overwhelmed by simply throwing money at it a la Goldman Sachs. It’s also possible the guy was trying to influence thinly-traded contracts with overwhelmingly-large positions in individual contract months.
Disaster! The fact is that the yield curve has been steepening and that has favored contango in gold futures during the past several months. For example, one of Shak’s presumed spread pairs, the long August 2012 and short December 2015 spread, went from a contango of about $100 per ounce in October to a contango of $160 per ounce last week when he threw in the towel. The wannabe gold trader may have had up to 6,000 of these spreads amounting to a potential loss of $36 million on just this one position. The loss probably wasn’t that big given the margin of approximately $2 million, but you get the idea. The fact is that massive spread positions can be carried for just a few million dollars in COMEX gold futures, which is still the largest gold “market” as measured by dollar volume in the entire world. That’s how small the gold market still is!
As an aside, it is interesting to note that the liquidation of Shak’s spreads did not result in an exchange volume spike and that means the transaction was probably arranged off the exchange with a bullion bank. In other words, Shak was stuck and probably could not liquidate without a loss exceeding 100% of his account. This “helpful” bullion bank is probably the same one that took the other side of Shak’s spreads in the first place. In turn, the bullion bank would have offset each of the long and short contracts dating all the way out to 2015 with various parties using over-the-counter derivatives and swaps, the result being that the 80,000 contract spread liquidation did have a substantial, if only short-term, impact on the gold market despite Shak’s “What Me? I’m Innocent!” shtick. It probably started several days before the liquidation and likely lasted for several days afterwards (and in fact could still have a waning influence right now).
There are all sorts of points and observations one can make based on this incident but one that we find particularly insightful is that the gold market is interdependent such that acting on one part of the market causes another part to react. Therefore if you know what to look for and where to look, it is not possible to disguise manipulation for very long. Moreover, taking the opposite side of a manipulator — in the gold market or elsewhere — will eventually result in a profitable trade assuming you are able to withstand the move against your position in the meantime.
Personally speaking, we are not fond of spread trades in gold (or silver) futures because they are closely correlated to movements in interest rates. In a few rare instances, spreads can still be traded profitably despite the interest rate dependence such as the TOCOM vs. COMEX gold disparity that resulted in Goldman Sachs making a massive shift in its net positioning a couple years back. Let’s be clear that Goldman did not lose money on this trade, rather they made a tidy profit on the arbitrage provided by the TOCOM-COMEX inter-market spread with basically zero risk. If we found a similar situation today, we probably wouldn’t hesitate to take advantage of it — although the opportunity would need to offer significant leverage to outright ownership of physical gold and silver.
This is where Shak’s strategy really went awry — instead of being down 70%, his fund would probably be up 20% or more at this point had he simply just bought gold and silver. This is really such a no brainer yet we suspect a large number of you who are reading this do not have a significant holding in physical gold or silver. If so, please do yourself a favor and start buying physical gold and silver today, or at least start very soon, and definitely don’t miss the opportunity next time gold and silver prices touch their 200 daymoving averages. It’s not too late although you should go about it carefully given that neither gold nor silver are today the screaming value they were a few years ago. At Metal Augmentor we’ll be spending a lot of time during 2011 providing ideas on what, when and where to buy.
[By the way, just because gold or silver spreads don't look that interesting doesn't mean spreads themselves can never represent a very good speculative opportunity. For example, there are currently at least two commodities in which spreads on futures contracts are so far out of whack that they are capable of generating very significant returns during the next few months. We believe these spreads are being influenced by positioning that is manipulative and therefore we expect that there could be an imminent reversion to the norm. These spreads are at least partially neutral to underlying price movements, meaning that we are not betting on prices moving up or down but rather for market conditions to start returning to normal.
For those with experience trading futures who have large speculative accounts and plenty of risk tolerance, we'll be describing these spreads in a separate commentary for Metal Augmentor subscribers. Even though not appropriate for most investors, our commentary will still be useful because we will describe concepts that can help both novice and experienced investors enhance their understanding of the commodity markets.]
