Gold is due a major correction

Today I want to write about gold. Because I believe we are in the process of making my long-awaited major turn. And I wanted to explain exactly why I think we could soon see a major sell off in gold.

Previously, I have highlighted the crowded trade nature of the market and have been looking for short entries.

As I signed off my last article, I had a short entry, the market was heading lower and my trade was in slight profit. Below is the chart from then.

I had my short entry at the pink bar – having bounced down off the upper tramline – and noted the bounce off the Fibonacci 38% retrace. I also noted the potential A-B-C pattern, which would indicate the bull market might be intact.

Those were the opposing forces at play at the time.

My downside target was the blue bar, but as we all know, the market never made it and continued its rally to take me out on my stop.

Gold spread betting chart

(Click on the chart for a larger version)

Was the market going on to make (and exceed?) the $1,800 level – and head for the skies?

Well I am not giving up on my quest for a major turn, despite making a small loss. I am nothing if not persistent!

The warning signs for gold

As I said on 1 October, my one eye is on the Commitment of Traders (COT) data – more on that shortly.

But I’m also aware of the frenzy of bullishness that has recently appeared in the blogosphere of late. I am seeing outrageous upside targets mentioned again. That is a huge warning light to me – it occurred last year as gold was rallying towards $2,000, but of course, fell short by a wide margin, thereby dashing bullish hopes.

Disappointment at not hitting $2,000 produced waves of liquidation and we made hay on that decline.

Today, I am confident the market has become too one-sided and due at least a major correction. But can I find any evidence to back up my COT hunch?

Last week, gold made a stab at the much-trumpeted round figure $1,800 – and on Friday, it came within $4 and promptly backed off. Here is the chart as of this morning:

Gold price spread betting chart

(Click on the chart for a larger version)

I have slightly re-drawn my original tramlines, but see how the market respected the lowest line on Friday and bounced up to make the $1,796 high before selling off into Friday’s close.

The important point is that this sell-off has produced a crucial tramline break.

Now we are getting somewhere – our first piece of evidence to suggest a major turn is at hand. But I need more – and here is the latest COT data:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
Contracts of 100 Troy ounces Open interest: 480,908
Commitments
239,434 31,108 26,727 136,250 405,520 402,411 463,355 78,497 17,553
Changes from 25/9/12 (Change in open interest: -8,608)
5,440 1,010 -5,914 -8,256 -1,341 -8,730 -6,245 122 -2,363
Percent of open in terest for each category of traders
49.8 6.5 5.6 28.3 84.3 83.7 96.4 16.3 3.6
Number of traders in each category
224 55 68 48 47 302 148

Wow! The large specs (hedge funds, exchange-traded funds (ETFs)) increased their longs so that they now hold almost eight long contracts for every one short (it was seven last time). As I never tire of saying, most people (even the pros) turn more and more bullish as the market rallies.

Trader tip: In fact, the correct position is to become more bearish as markets extend rallies. It is the ‘selling high’ part of the universal law of profits which states: ‘buy low and sell high’. How tough to put into practice as we are caught up in the bullish excitement, especially if heavily long!

Even the small specs are throwing in the towel as they covered shorts.

To me, this is a textbook set-up for a major top soon, if not already made on Friday.

So I have two solid pieces of evidence. Can I find any more?

The last piece of the picture

I believe I can – and it involves Elliott waves.

Here is a close-up on the 15-minute chart showing the form of the decline off Friday’s high:

Gold price spread betting chart

(Click on the chart for a larger version)

I can count five complete waves with wave 3 being strong (but not long). Wave 4 is complex – a normal pattern – and this morning, we have a new low in wave 5.

This is the pattern I have been looking for! It indicates that with high probability, the trend has now changed and I can expect a rally (in an A-B-C?) to perhaps the Fibonacci levels marked by the pink bar.

That is my third piece of evidence, so I rest my case.

And adding to my evidence is the fact that the market has rallied to the Fibonacci 62% retrace of the huge move down from last year’s $1,920 high to major support at the $1,530 area.

But of course, if we do see a larger immediate sell-off, my Elliott wave labels may be part of a larger pattern with my wave 3 a larger wave 1, my wave 4 a larger wave 2 and we could be currently in a larger wave 3. That would be a very ominous development for the bulls. But my small-scale five-wave pattern still holds.

How low could gold go?

So where are the chart points that are the signs along the way to tell if we are really in a large third wave?

Gold price spread betting chart

(Click on the chart for a larger version)

We are already working through the first area of chart support (pink bar). The next is the blue bar surrounding the next minor low, and the third is the green bar around the major low just below $1,740.

Incidentally, the further down from the common $1,800 target the market may fall, the more anxious the longs will be to grab profits while they are still there. This occurred last year off the $1,920 high, as the market was hit by tsunamis of panicked selling.

I sense exciting times lie ahead.

Finally, eagle-eyed readers will have noted the large negative momentum divergence at Friday’s high!

• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading

Advanced tramline trading

An introduction to Elliott wave theory

Advanced trading with Elliott waves

Trading with Fibonacci levels

Trading with ‘momentum’

Putting it all together

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