by Adam Hamilton, Zeal LLC:
Futures speculators have responded to this year’s extreme bearishness plaguing gold by amassing wildly-outlying record short positions in it. These huge and highly-leveraged bets can only be unwound by buying gold futures to cover the shorts. As gold continues rebounding out of its recent hyper-oversold lows, the futures traders on the short side will have to buy. This will likely fuel a massive short squeeze.
Major short squeezes are the stuff of market legends, rare and extreme events. Whenever a price falls particularly far and fast, traders wax exceptionally bearish on it. They extrapolate the downside action continuing indefinitely, and some want to play that momentum. So they reverse the usual trade of buying low then selling high. They effectively borrow the asset from someone else to sell it in the open market.
Naturally whatever is borrowed must be repaid. If the short sellers are right, if the downtrend continues, they can buy back the underlying asset later at a lower price. They strive to sell high then buy low, the difference pocketed as gains. This buying to return the underlying asset to its original lender is called covering. It’s in this covering that short squeezes are born, when prices turn against the traders shorting.
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