By Rick Pendergraft

(Editor’s Note: Over the next few weeks the League of Power will be running a special and timely series from master trading expert Rick Pendergraft. You may recognize Rick from his numerous appearances on CNBC, Bloomberg and Fox Business News)

Over the last four months, gold has been mired in a downturn that has taken the price down to the $1,550 for the fourth time in the last year and a half. Each of the previous visits to this level resulted in the area acting as support. In fact, for the last 12 months, gold has been in a trading range between 1,525 and 1,800. Looking at the weekly chart we see the two rails of the trading range, but it is the bottom part of the chart that I want to focus on.

That red circle in the bottom portion of the chart shows how gold is the most oversold it has been in a number of years based on the 10-week Relative Strength Index. In fact, in order to find gold in a more oversold state than right now, you have to go all the way back to the summer of 1999.

The oversold condition is only part of the story on gold. The sentiment toward gold has been moving away from the bullish camp for some time now.

The best sentiment indicators for commodities are the Commitment of Traders (COT) reports that are issued every Friday by the Commodity Futures Trading Commission. The report is broken down into three categories of investors and a net position is given for each of the categories.

The three categories are Large Speculators, Small Speculators and Commercial Hedgers. The difference between large speculators and small speculators is based on the number of contracts being traded by the investor. Commercial hedgers are those within the industry that are protecting themselves from a major price move–miners, explorers, etc.

Once the investors are categorized, the number of contracts being held long (bullish bets) are added up and the number of contracts sold short (bearish bets) are subtracted from the number of long contracts. A positive number means the group is net long while a negative number means the group is net short. For instance, if the large speculators are long 150,000 contracts as a group and short 50,000 contracts, the net position is a net long of 100,000 contracts.

When analyzing the COT report for each commodity, it is best to compare the results to the previous readings for that commodity. What I mean by that is you don’t want to compare the COT report of gold with that of corn–it is irrelevant.

Now that I have explained the COT reports and how they work, I can explain what is happening in the COT report for gold. As of Friday, the large speculators are net long 103,651 contracts. As I mentioned earlier, you want to compare the current readings to the previous readings for the same commodity. For gold, large speculators are rarely net short. In fact, the current net long position is the lowest net long position since November 2008.

Looking at the most recent COT report, we see the declining bullish stance by the large speculators. Just three months ago, the group was long over 200,000 contracts. Think about that–to go from a huge net long position to the smallest net long position in four years and it only took three months. That is a huge shift in the sentiment toward gold.

If you look at the chart for gold above, you might also take note of where gold was in November 2008–the last time large speculators were long less than 100,000 contracts. The price was between $700 and $800 an ounce, but approximately one year later the price had soared to $1,200 an ounce.

So how do you take advantage of this situation? Personally I think the best way is to buy a gold exchange traded fund (ETF). The two most actively traded gold ETFs are the SPDR Gold Trust Shares (GLD) and the iShares COMEX Gold Trust (IAU). I like the IAU better because it is one tenth the price of the GLD and they move in sync with one another. By buying the lower priced fund, you can buy more shares and this allows you some flexibility when it comes to closing a portion of the trade, etc.

I like the IAU well enough that I just added it to the portfolios of my clients during the past week. If we see a similar move this time as we did from November 2008 through November 2009, the IAU would move from the $15 range to a price above $24 and investors would be looking at a gain of 60%.

Regards,

Rick Pendergraft