My split-bet strategy works

On Monday, I outlined what I believe is one of the key elements in learning how to become a good trader. You need a certain level of understanding of yourself to prosper in what is one of the toughest careers in the world. There are no rewards for failure here.

Let's say you are a Trader A type (see Monday's post) and bought gold last December at the $1,080 level and saw it embark on a terrific rally to the recent high at the $1,280 level. You had analysed the charts last year and concluded that the market was oversold with hedge funds massively bearish.

You had learned that this is often a setup for a big reversal after a long decline because you know that hedge funds are mostly trend-followers and are totally unprepared for trend reversals, especially when they have all moved over to one side of the boat.

On the other hand, you have learned that joining a massive herd is a dangerous game, no matter what your personal views are. You may be bearish gold, but you acknowledge that downtrends can be interrupted by large counter-trend rallies. To avoid taking a likely big loss by shorting just when you feel bearish, you override your feeling and decide to play the long side.

You see, Trader A types are flexible and can play either side of the market and recognise that market participants swing from being bearish to bullish, and the switch occurs when bearish sentiment is extreme. That is the time to trade against the herd.

But up to February, the market had only reached the $1,120 area. What would a Trader B type do? He or she may decide to grab the profit. They rationalise it by noting the rally has been steep but the main downtrend must resume at any time and take away his or her hard-won gains.

As the market soared by another $150 in March, Trader B would stand there transfixed and too scared to re-enter this dynamic bull run. B would rationalise it by noting that it cannot go much higher as it must turn back down hard soon and hand me a thumping loss if I got in here.

But when the market had reached that $1,280 level, B could stand it no longer seeing his/her lovely market that they had worked on for so long make a major move without him/her was exceptionally painful.

And that is when B placed the fateful order to go long right at the top. We all know what happened next B's head was handed to him/her as a stark lesson in timing.

What is a more sensible strategy? We all know that markets are probabilistic and we cannot be sure our careful analysis is correct. So we must have a plan when in a trade of how to manage it and that is why I developed the very simple split-bet strategy.

Trader A would have placed a spread bet in multiples of £2 per pip at the start in December. Then, A would note the rapid progress in January and February and have done nothing A would have left well alone, recognising the market was almost certainly in a third wave up, safe in the knowledge that third waves are long and strong.

Then, when the market hit an important Fibonacci level or a significant tramline or another reliable signal, A would look to take one half of the position off, leaving the other half open with protective stop at break-even (entry price) or even closer to the market. A would expect the market to take a breather after such a long ride but crucially, did not know how deep a correction would ensue.

The psychology is important. By banking half of the profits and guaranteeing a zero loss on the other half, A has effectively freed him/herself from all of the anxiety that Trader B would have. B would be worrying about his/her position every waking moment and usually getting out at the wrong time just when the stress became unbearable.

I advocate using the split-bet strategy to traders and long-term investors. In fact, for larger accounts, you can split your initial stake into three parts (or more) which gives you even greater flexibility.

Finally, today sees the monthly Fed interest rate charade pronouncements and tomorrow it will be the turn of the Bank of Japan. Volatility usually accompanies such events but the main trends are already set.

Here is my Elliott wave take on gold:

On the very large scale, the December plunge was my A wave off the 2011 high at $1,920. The current rally is large red wave B that should carry to at least the $1,350 - 1400 area. But in the meantime, we shall see many twists and turns of course.

The rally to the $1,280 level last month was my purple wave 3 and the correction is wave 4 in the shape of a wedge, which is a typical form for fourth waves. When wave 4 has played out, wave 5 should send the market to well above the $1,280 level and possibly above $1,300.

And that would complete wave 1 of red wave B to be followed by a decline in a large wave 2. That decline will test the mettle of most bulls. But Elliott wave followers will expect it and we'll know how to handle it, won't we?