Gold follows my game plan and rallies

I was in Pisa last week, and found the statue of the great Fibonacci, where I paid my respects.

Taking a break from the markets can give me a fresh perspective on my return. Everyone should try it now and then.

But I have to say that my view on gold before I left has been playing out exactly as I thought it would. And on this occasion my perspective hasn’t changed a bit.

Let’s review the situation in the gold market last month, when it was in freefall.

The decline was so severe that sentiment had plummeted. And as gold fell below the critical $1,200 level, there were a miniscule 3% bulls. This was very significant, and I mentioned it in my last post on gold.

In fact, this was the mirror image of the situation when gold made its all-time high of $1,920 in 2011. A reading of 3% bulls (or bears) means that all hope (or fear) has been abandoned by the majority, who have been driving the trend their way.

At the sub-$1,200 lows, there were precious few bullish articles. The overwhelming theme was “how low can gold go?”

When I read this, I just know at least a temporary low is near, as damage limitation has set in. That is a very negative emotion.

But most developing traders become swept up in the negative mood as prices plummet. They adopt the same ‘how low can it go?’ mentality. This is classic herding in action.

My advice is always take a step back from the high emotion and examine your charts rationally. In my last post on gold, I gave several good reasons (and charts) to suggest a low was near and that a long trade could well work out as the 97% of bears are likely to be squeezed.

Many see this tactic as akin to trying to catch a falling knife. Yes, with no solid evidence for a possible turn and working on just a hunch, buying a falling market is often a loser.

But sometimes, you can catch the knife by its handle!

A safe entry point

This was the hourly chart I had then:

Gold price spread betting chart

The first clue that the selling was drying up is the nice positive-momentum divergence (red bar). This is a classic sign of an impending counter-trend rally. It is your advance warning to prepare for a possible long trade.

And with my tramlines, you have a sensible entry point – and crucially, a sensible position for your stop loss, thus giving you a known risk even before you enter the trade.

Armed with this data, you can then decide whether you wish to take this trade, or pass it up as having a risk that exceeds your established limit – a limit that you will adhere to with discipline, I trust.

For instance, I have a 3% rule for smaller accounts – no single trade will lose me over 3% of my capital. This is an iron-clad requirement and if it means passing up some trades, then so be it. There will always be another great trade coming along.

OK, just before I left for my break, the market was in rally mode. I made this projection on 2 July:

Gold price spread betting chart

I believed the most likely scenario was an A-B-C formation as outlined in green. Was my forecast correct?

Yes. When you see a highly trending market, such as we had in gold, the most common form of relief rallies are A-B-Cs.

And yesterday, this was the situation:

Gold price spread betting chart

And there it is – a lovely A-B-C with my tramlines showing that wave A = wave C as gold hit $1,298 yesterday – and right on the tramline.

With a slight negative-momentum divergence at the C wave high, this was an ideal place to take profits off the table for a good 700-pip or so profit.

Since the market has now satisfied all Elliott wave requirements for the completion of the counter-trend rally, there is no longer any valid reason to hang on to long trades (for a swing trader, that is).

My next task is to identify my next trade.

Is it possible that the counter-trend rally has finished and the bear trend can resume? Certainly.

Easy money?

But is the market ripe once more for a decline? One clue may lie in the latest commitments of traders (COT) data. During the short-squeeze of the A-B-C, if there was a substantial reduction in short positions, especially by the small traders, accompanied by a build-up in longs, then that could provide the fuel for another leg down.

But if there was a large swing to a net short position, that could lend support to the rally. Let’s see the latest data from 2 July:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
(Contracts of 100 troy ounces) Open interest: 410,399
Commitments
158,712 137,961 27,133 186,385 209,161 372,230 374,255 38,169 36,144
Changes from 06/25/13 (Change in open interest: 19,752)
-6,189 7,212 5,275 21,427 8,995 20,513 21,482 -761 -1,730
Percent of open in terest for each category of traders
38.7 33.6 6.6 45.4 51.0 90.7 91.2 9.3 8.8
Number of traders in each category (Total traders: 292)
115 95 72 61 54 209 193

 

The hedgies had a large net swing to add to their shorts, while the small traders took some short positions off the table.

This data was taken at the A wave high and so with the added spec shorts, the decline only took it to the B wave low before the rally resumed. No doubt we will see the hedgies adding even more shorts before the B wave low – this data will be released later today.

I am quite sure the C wave rally surprised a lot of shorts as they expected a move towards their much-publicised lower targets.

I will examine the new COT data today for guidance, but the evidence so far points to an immediate decline off the $1,300 level. But the market certainly has the potential to stabilise and go on to make a larger A-B-C, after first dipping from current levels.

It appears the easy money has been made.