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Quite possibly one of the most
frustrating things about the financial markets is the fact that you can be
dead right and end up dead broke. It's a terrible sensation, nothing else
compares to it, and it especially holds true with gold. A lot of people I
know have been bullish gold for the last four years, invested according to
their beliefs, and have lost money. How can that be you might ask? In my
opinion it's a combination of volatility and greed, with the emphasis on
greed. It's my opinion that these two will only increase over the coming
months and years so adjustments must be made. There is an old saying that
there is nothing new in the markets and that's as true today as it was when
tulips were all the rage. The reason it's true has to do with human nature. Emotions
like greed, fear, love, and hate have been around since man began to walk
upright and almost everyone is a slave to their emotions. There are
exceptions to the rule: Warren Buffett and Tiger
Woods come to mind. They maintain an even keel when all else about them are
losing their heads. People who enjoy outstanding success do so because
they've learned to channel their emotions into something productive. The rest
of humanity never quite gets to that level and that's why it's always one
step forward and two steps backward. It's not that they don't have the tools
because they do. It's just that they're poor craftsmen. In this article I am
going to show you how to overcome your emotions, develop a plan, and
discipline yourself to act and not react. I will use gold as an example.
For purposes of this analysis, I
am going to use November 15, 2006 as a starting date[1].
I'm also going to make certain assumptions: you have US $20,000.00 in
capital, you'll invest in the futures market, and you possess certain knowledge[2]
with respect to gold's behavior over the coming
months. The knowledge you possess is the following:
- We
are in a bull market for gold that began in 1999 when gold bottomed at
US $252.00/ounce.
a
- The
bull market in gold will last until 2010, at the very least, and top out
at US $3,000.00.
a
- There
are key Fibonacci support/resistance numbers at the following spot
prices: $602.70, $624.60, $644.50, $664.50, $686.20, $728.60, and
$775.00.
a
- There
is also resistance at the modern all-time high of $882.50.
a
- The
current leg up will take us to a minimum of US $775.00 and there will be
two corrections of 7% along the way.
Before I can put this knowledge to
work, I have to decide if I am a trader or an investor. Traders
are usually trying to time the secondary and even tertiary reactions, getting
out at secondary tops and buying back in at secondary bottoms. With the
possible exception of cotton, gold is the most difficult market to
"trade" and I personally know of no successful traders. Therefore
"investing" wins by default, at least in my mind. Besides I want to
benefit from every single dollar of price escalation in this
once-in-a-lifetime event, and the only way to do that is to sit tight. Finally,
I will use the bottom of secondary corrections (corrections greater than 15%)
to add on to my current position but I will not sell what could be secondary
tops. Why not sell tops? Simply because somewhere down the road there we be
an "event" similar to or worse than 9/11, and it will drive the
price of gold up several hundred dollars in a single session.
Now let's get back to what you
claim to know. Knowledge in and of itself is useless unless you can figure
out a way to transform this knowledge into cold hard cash. Well, you have to
have a plan and you have to have the discipline to stick to it. Easier said
than done, especially the discipline part! Here's the plan. You will buy two
June 07 gold futures contracts at the spot price equivalent of US $615.00. This
will require approximately $6,000.00 in margin meaning that you are 30%
invested. You will use the Fibonacci number at $602.70 as a stop/loss on a
closing basis. As a reference, for every dollar of change in the futures
contract, that presents a change of $100.00 in your account. If the price of
the contract increases by $10.00, it means a $1,000.00 profit times two, for
a gain of $2,000.00 minus any commissions for the purchase of the contracts. In
order to invest, you have to know what you are willing to risk. If gold were
to close at $602.00, you would be stopped out. That equates to a loss of
$1,300.00/contract for a total of $2,600.00. Your trading account would then
have a balance of $17,400; not what you had in mind but you would live to
fight another day. Fortunately, the closing price never dipped below $606.90
once you bought your contracts on November 15th, so you have your foot in the
door.
Surprisingly enough, most
investors get this part right. Problems usually creep in once they get some paper
profits in their account and greed begins to rear its ugly head. Right
about here I should tell you that investing in the stock market goes against
human nature. Instinctively people begin to think of these "paper"
profits as theirs and they begin to fear that they'll evaporate. The
reality is the market has now confirmed you're right and that is nothing to
fear. You should be happy; all your hard work and analysis proved to be
correct. Now what do you do? The correct answer is nothing except sit and
wait. You have to fight the desire for constant action. Unlike a nine to five
job, you're not working for wages and you don't have to be doing something
all the time. A really good investor makes very few trades and spends most of
his time waiting. Wait for what you might ask? Before you invest any more of your
hard earned money, you want to get the first 7% correction out of the way. You
see markets have a way of giving you whiplash and that's precisely what
happened. By late November the price had reached $655.00 and I'll admit that
I was feeling more than a bit left out but I held my ground. Good thing too
because we fell all the way back down to $609.00 on a closing basis and the
paper profits were up in smoke. Fortunately, your capital was almost all
intact. If you would have added on at $624.60 and $644.50, and sat on them,
you would have had a margin call around $615.00. That's when a broker calls
you and tells you that your account is close to zero and he needs more money
or he'll close you out. As a matter of interest, the first correction turned
out to be 7.3%. Gold then spent a week or so consolidating in the $615.00
range and promptly headed back up.
With one correction out of the
way, you should feel a bit more secure about buying break outs above
Fibonacci resistance numbers. In particular, you would decide to buy one
additional contract with a close above $644.50 and that is precisely what
would have happened in mid-January. A week later you would do it again on a
close above $664.20. Gold closed out the month of January at $673.90 and
you're long four contracts. Your paper profits are now $15,500 for a total of
$35,500. Also, you have used $12,000 of margin which means that you are still
33% invested. It just goes to show you that you don't have to
"plunge" in order to turn a profit. Now comes the important part so
pay attention: the money is great but what really matters is that your
analysis and plan are on track. You need to realize money is the affect
while the plan and analysis are the cause. Most people never quite
catch on to that subtlety. Now your capital is safe and you're using house
money to take any further risk. That gives you confidence in your projections
for the future. As of February 22nd gold closed at $683.00 and is just shy of
the $686.20 Fibonacci resistance and the question is what to do once we close
above it. The answer is nothing! I will sit tight and wait. Wait for what you
query? The second 7% correction, that's what. My guess is that we'll see it
somewhere between $710.00 and $728.00, but that's just a hunch. If we correct
at $728.00, that would imply a $51.00 decline and a $677.00 bottom. There is
another possible world where we would correct at $686.20. That would mean a
decline of $48.00 down to $638.16. It's possible but not very probable. Even
if the unlikely happened, your account would still show a profit so you can
sit through it and still come out all right, and that is exactly what you
should do.
My real concern is not if we
correct, but rather what to do if we don't get the expected correction at
$728.60? If I were to see two consecutive closes above $728.60, it would
indicate to me that we are going straight to $775.0 and the trip up will
probably be a fast one. I don't want to miss that so I would buy one more
contract on a close above $728.60 but I would put a $712.45 stop/loss just in
case the market tries to trick me. On the
other hand, if the correction comes at $728.60 as expected, and we fall back
down to $677.00, you can buy on the way back up with a close above $686.20
and again at $728.60. That's the most likely scenario and that would mean
that you would arrive at my $775.00 price target with six contracts and
$68,000.00 in paper profits stuffed into your trading account for a total of
$88,000.00! Finally, at a gold price of $775.00, you would be using $18,000.00
in margin which is just 20.4% of your account. This all means that you more
than tripled your money while never being more than 35% invested at any one
time, and you never risked more than $2,500.00 of your original capital. There
was no slight of hand and no magic was necessary. I didn't make any
outlandish assumptions or take outrageous risks. I analyzed the situation and
acted responsibly. That's how real money is made. Better yet, that's the only
way real money is made in the stock market.
The final question now becomes:
what do I do at $775.00? The answer as always is: let the market tell you. I
would probably tell the average investor to take his original capital out
along with another $20,000.00 thereby insuring a 100% profit. Put the money in
30-day treasuries and let the interest build up until another opportunity
comes along. Then I would reduce my position to long 2 contracts and with a
$750.00 stop/loss on a closing basis. In all honesty, I don't know if we'll
correct at $775.00 but I firmly believe we'll see a $775.00 print. There is a
decent possibility this leg up well take us to the historical all-time high
of $882.50 or even a bit higher. The following Point & Figure chart is
interesting in that it shows an even more bull-ish
price target of 790.00, so my $775.00 price target is in line with reality.
I like P & F charts because
they strip all the garbage and worthless opinions out of the analysis and
boil it down to pure price movement. I will tell you this much though, if we
don't stop at the $775.00 to $790.00 range, the sky literally could be the
limit. That's why I always stay at least 25% invested in gold, always. In
fact, since April of 2004 I have not sold a single contract. I've sat through
every correction as unpleasant as it sounds. Currently, I am projecting a 25%
to 30% correction once this leg is over and I have yet to decide what I will
do. The most I would do is "lighten up", but I may decide to sit
through it anyway. As I mentioned preciously, I do believe we'll see an event
that will turn the markets upside down and if I found myself on the
sidelines, I wouldn't be a very unhappy camper. I can't imagine sitting
through everything for four years and then missing the main event.
References
1 - I
chose this date because I published an article on that date saying what gold
was going to do in the coming months.
2 - This
knowledge was outlined in the November 15, 2006 article just as it appears
here.
Enrico Orlandini
Dow Theory Analysis
Ignacio Merino 636, Santa Cruz, Miaflores,
Peru
Phone: 001-51-56-973-5599 - Fax
: 001-51-19-280-8796
Email: ebo@dowtheoryanalysis.com
Website: www.dowtheoryanalysis.com
For those of you interested in receiving
information on the Funds we manage, please feel free to e-mail us at ebo@dowtheoryanalysis.com and we will respond as soon as possible.
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