Short-term trading with Elliott waves – a textbook gold trade

As a swing-trading spread-better, I am on the lookout for situations that offer good profit/risk potential. These situations can be both long and short trades in any type of market conditions, whether it is in a bull run, a bear run, or just consolidating.

Gold is one of my favourite vehicles. It trades virtually 24 hours and is highly liquid. It also has the benefit of being the subject of intense speculation. Even professional money managers, who previously had dismissed gold as a ‘barbarous relic’, are now taking great interest in this market.

As a measure of the speculative fever surrounding gold, I have taken from the latest report (28 December) of the US Commodities Futures Trading Commission the breakdown of futures positions held by the ‘managed money’ group. These are mainly the hedge funds and represent the ‘big money’. Managed money holds 180,000 contracts long, and 12,000 contracts short.

You can see what has happened. Just about everyone has bought the gold story. We see forecasts of gold going to $2,000, then $3,000, and then – the moon. Even the small independent trader is massively long gold (77,000 on the long side, and only 29,000 short).

I trade against the crowd, so naturally, I am looking for an opportunity to short gold against the crowd. With this degree of bullish mania, any dip could turn into a rout – and big profits for the nimble.

With my strategy in mind, in late December I was watching the market work its way higher towards the previous peaks in the $1425 area, which were made in early November and early December.

The market was forming a potential rare triple top. I believed that if this level held, there would be enough profit-taking and new short-selling to drive the market down in the rout I was expecting.

By then there was enough trading to form a very solid pair of tramlines on the hourly chart. I felt that if the market broke down below my lower tramline, that could be the start of my rout. Many sell-stops would then be touched, and a nice snowball selling pattern would ensue.

I then placed my entry sell orders just below the tramline and my order was filled on 4 January.

I decided to bet with £2 per pip, and my protective stop was placed at $1,420, as I reckoned that if the market rallied to that area, it would negate my analysis. This represents a potential loss of £160. My account had grown from the original £4,000 to over £5,000, and this higher risk was now justified.

• 4 Jan sell £2 rolling gold @ $1,412 
• Protective stop @ $1,420 
• Risk £160 (3% of account)

The market quickly dropped below support at $1,402 (the low of 30 December), and I lowered my protective stop to break-even, following my break-even rule.

I now recognised that we were in a possible wave three of a five-wave Elliott wave pattern, since the drop to the $1,385 area was so swift. This is the most important characteristic of a third wave – they are most often sharp and swift, and it was forming right before my eyes.

OK, so it looked like we were in a potential five-wave pattern, but what should I expect now?  Clearly, we had waves four and five to come. Wave four would be a short bounce off wave three, and then finally, wave five should drop beneath wave three, preferably on a positive divergence with momentum. I would be looking to take profits as close to the bottom of wave five as possible.

On 5 January, I was closely watching the market as it made the slight rally to wave four at $1,384, and then was delighted to see it drop below wave three to confirm my forecast of a minor five-wave Elliott wave pattern. According to Elliott wave theory, after a major bull run, if the market turns and makes a minor five-wave pattern down, that is almost certainly the end of the bull run.

My decision now was where to take profits – a nice situation to be in.

As the market made it to $1,363, I was looking for a spot to exit the trade. As the positive divergence was so great, I expected a good rally. I pulled the trigger at $1,370 for a very satisfying two-day trade, where I caught a $42 move.

• 5 Jan bought £2 rolling gold @ $1,370
• Profit 420 pips, or £840 on risk of £160

With Elliott wave forecasting, you need to make lots of assumptions. I had forecast a rapid move down below my tramline as sell-stops would be hit, and I based this forecast on the massively long market.

Incidentally, those on the matching short side are the trade – mainly the miners that actually dig the stuff. They are simply hedging their production, current and future. Generally, they do not employ buy stops on their positions, whereas the speculative traders must and do. That is one reason why most of the time, when the market dips, there is a sea of red, while rallies in gold are grinding green and red affairs.

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