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November 10, 2006

Trading the Gold Bull 2
by Adam Hamilton

Gold has been incredibly volatile since it began rocketing higher in March. Starting near $540, the Ancient Metal of Kings soared to $720 in a magnificent climax for the biggest upleg yet in its young bull market. Then after initially plunging back down near $560 in June, the metal has largely drifted sideways ever since.

From March to May alone, gold blasted 33% higher. And from May to June alone, it plunged 22% lower. This degree of raw volatility would be impressive for a stock, but for history's ultimate form of money it is staggering. When this volatility is considered across the world's entire gold supply, its effect on wealth is breathtaking.

Assuming that all aboveground gold in existence is running 129,000 metric tonnes or so (per the US Geological Survey), at $540 in March the world's gold supply was worth $2240b. But by $720 in May, this same gold was worth $2986b. Thus a staggering $746b in wealth was created in that stunning surge! And then when gold fell back down to $560 a month later, $664b of this windfall suddenly evaporated.

These numbers are so big they defy comprehension. Near its record highs at the end of October, the elite Dow 30 blue-chip stock index was worth $4048b in market-capitalization terms. In order for the Dow 30 to generate the same amount of wealth that gold did between March and May, the Dow would have to soar over 18% in about two months. We are talking about an extraordinary amount of capital here.

With such massive swings in the gold price, its allure for trading becomes irresistible. If there was some way to reasonably assess when probabilities for a major interim top or bottom were very high, a speculator could ride gold to some truly legendary gains. This could be done directly through leveraged gold futures and futures options or indirectly via elite gold stocks.

All this has me thinking about the game of trading gold again. After studying this bull market relentlessly since its stealthy birth in April 2001, I have seen and applied many technical indicators to attempt to divine gold's next move. There are a few indicators I have developed myself and many others devised by minds far more brilliant than my own. Yet over the years I keep gravitating back to moving-average-derived indicators.

Moving averages are very simple. All they do is take the closing price of gold over X number of days and average them, with today's close being added to the series and the oldest close in the series dropping out. Like giant tunnel-boring machines, over time these moving averages gradually inch their way into lines that form trends.

By observing how gold's price interacts with its moving averages, much can be learned about its most-probable short-term course of action near major reversal points. And it is just these major reversal points, major interim highs and lows, that are the most profitable times for speculators to recognize early and capitalize upon.

Interestingly moving averages probably work as indicators because of the external discipline their gradual nature forces onto always-anxious trader psychology. We speculators, by our very nature, always want to trade. We are not very patient and we have a hard time waiting for solid evidence to accumulate on whether a major interim top or bottom has been seen. Our focus is also myopic. Our minds tend to weigh today's news, bullish or bearish, much more heavily than they should. This selection bias is very dangerous.

The study of moving averages forces us to temporarily step out of the hyper-kinetic flow of information. Since moving averages meander slowly like rivers compared to daily prices bouncing around like an electrocardiogram, their soothing lines force our minds to calm down. The long waits they impose on us while their curves gradually change force us to be patient and not be unduly influenced by short-term price action.

And since each day's close is weighted perfectly equally in a moving average, today's news events which are more likely to influence our psychology have no more impact than news events of months ago. Considering prices in moving-average terms therefore serves to eliminate the selection bias that causes us to overweight the significance of today's news far more than it typically warrants.

I believe a combination of moving-average-based indicators can provide speculators with a great read on probabilities in gold. The better we understand probabilities, the greater our odds of trading near major interim tops and bottoms when it is most profitable. Before I get into the primary and secondary moving-average indicators I am applying to gold though, an important caveat is in order.

I love gold as an investment. For a myriad of reasons everyone should have physical gold as the foundation of their investment portfolio. This investment gold should be held for the long run, until this commodities bull fully runs its course likely a decade from now, and not be traded. My essay today on gold trading absolutely does not apply to long-term physical gold positions held as investments. Trading gold is for neither pure investors nor gold considered as a pure investment in your portfolio. Don't trade long-term investments!

But in almost every portfolio some smaller amount of capital is allocated to pure speculation. This might be used to buy options, to buy junior gold stocks, or trade in other high-risk speculations. Trading gold is an idea solely for pure speculative capital, money not important to your future that you wouldn't shed a tear for if it was lost in trading. Trading gold is risky and the possibility always exists that speculators could either miss a big run higher or get trapped in a big slump lower.

Thus this essay is primarily for speculators and speculative capital. Investors can still benefit from this knowledge though, as the interim bottoms identified by these indicators also happen to be the best times to add to long-term gold positions if you want to deploy more investment capital midstream in this bull.

To trade gold I have been pondering combining moving-average-based indicators. A fast-moving indicator is used as the primary to alert traders to the growing possibility of a major interim high or low. Then a separate slow-moving indicator is used as a secondary confirmation a little after the high or low has been carved. Used in concert, these indicators seem to have a high probability for success as you will see below.

The primary indicator I am using is rGold, relative gold. This is very familiar to those who have been following our trading at Zeal. It involves taking the gold price and dividing it by gold's 200-day moving average. The result expresses the gold price as a multiple of its slower-moving trailing 200dma which helps speculators discern when gold is overbought or oversold enough to be near a major interim reversal point. The logic behind this concept is described in depth in my "Relativity" essay.

The secondary indicator I am using is called the Gold 50/200 MACD. I was looking into this as an indicator several years ago before I developed the Relativity concept while working on VIX-based stock-index trading. It divides gold's 50-day moving average by its 200dma. The MACD acronym stands for Moving Average Convergence and Divergence. Depending on whether the 50dma is converging to or diverging away from the 200dma, this indicator can impart a lot of valuable information on probabilities.

In my charts this week, gold and its two key moving averages are graphed under rGold and the Gold 50/200 MACD. Relative gold is charted in red while the MACD is rendered in light blue. In this initial strategic view, the timing of each of these indicators is evaluated relative to all the actual major interim highs and lows in our gold bull to date. The closer to a major interim high or low that an indicator turned, the better it is.

For each major upleg and correction of this gold bull, four numbers appear in this chart. The first is the percentage gain or loss during the major move and the second is how long the move took in trading days. The third row shows the offsets in trading days from gold's actual interim reversal point to when the indicators maxed out. Red is for rGold and light blue for the MACD, and positive days mean days after gold's actual interim high or low.

For example, in gold's fifth major upleg which just topped this past May, gold soared 74.7% over 316 trading days. The primary rGold indicator hit its highest point on the same day gold topped so it has an offset of zero trading days. Meanwhile the MACD didn't top until 18 trading days after gold's major interim high so it has an offset of +18. Looking at these two indicators' bull-to-date performance is quite illuminating.

Relative gold, since its numerator is the raw gold price, tends to top or bottom exactly when gold does. I have long liked this immediacy which is one of the reasons I have integrated Relativity concepts so deeply into our trading at Zeal. All the rGold offsets are zero days except for two, on major bottoms 2 and 5 for gold. But interestingly in both cases gold was just consolidating sideways so a trader buying on the delayed rGold bottom would have entered gold at essentially the same price as gold's real interim low earlier.

The big problem with rGold though is deciding how high is high enough or how low is low enough to call a major interim high or low in real-time. For much of the gold bull until this year, rGold seemed to top out near 1.14x gold's 200dma. But then in gold's first Stage Two upleg it soared much higher, exceeding 1.20x initially and ultimately challenging 1.40x on gold's terminal surge this past May. The rGold ambiguity on the interim-low side is much less pronounced, but still there.

So rGold does an excellent job of showing when gold is overbought or oversold relative to its 200dma baseline. And since it tends to hit its extremes on the same day as gold it is a great primary trading indicator. But the main problem with rGold is trying to decide in real-time when it is high enough or low enough to signal a high-probability tradable reversal. Yes, it does tend to trade in a horizontal range that helps this process, but as this year's massive gold upleg illustrated this range is certainly not set in stone.

Enter the Gold 50/200 MACD. Since this indicator is built from two moving averages and no raw price data, it tends to meander very slowly as the light-blue line above reveals. This inherent slowness is the best feature of the MACD. Since it takes time to adjust to price action, once the MACD reaches a high or low and turns, it is usually a darned good bet that gold has indeed just seen a major interim high or low. The MACD doesn't change from an upward to downward slope or vice versa very often, so when it does it is worth paying attention to.

But the problem with the 50/200 MACD is its big offset. As you can see by the light-blue numbers above, major highs and lows in the MACD tend to occur significantly after the corresponding highs and lows in gold. Moving averages by their very nature smooth prices and lag behind today's price, so this is not surprising. These offsets can be considerable. They averaged 19 trading days after major interim gold tops and a whopping 69 trading days after major interim gold bottoms.

Because of this inherent lag, I abandoned the MACD several years ago as a primary indicator. Especially on the major interim-top side of the gold trading game, it was just unacceptable that the MACD signaled the top about a trading month after it had already passed. It just wasn't precise enough to use as a sole basis to call major tops and bottoms in real-time to facilitate profitable trading.

So as you can see both Relative Gold and the Gold 50/200 MACD are double-edged swords. They each have strengths and weaknesses. rGold is fast and responsive yet it is hard to tell when it hits an extreme in real-time since it can jump out of its trading range and is as volatile as the gold price. And the MACD doesn't turn higher or lower often so its intermediate-trend signaling is excellent, but these decisive signals happen some time after the optimum tradable tops and bottoms in gold.

But what if these moving-averaged-based indicators are combined? Their respective strengths tend to offset each other's weaknesses to a considerable degree. We can combine rGold's responsiveness with the MACD's decisiveness and have a pretty solid system that does an excellent job of signaling and confirming gold's major uplegs and corrections early on in these moves when there is still plenty of time left to execute very profitable trades.

This next chart outlines my initial ideas on this binary trading indicator and applies it to the gold price over the last several years. I will walk through some of the major interim highs and lows in gold over this period of time and explain how these two indicators working in concert would have helped gold speculators game major reversal points quite well. And if you are an investor who wants to buy more physical gold, please pay careful attention to the bottoming methodology here as it could serve you quite well.

Before we walk through this chart, there are a couple key trading principles to keep in mind. First, bull markets tend to surprise to the upside. So rather than selling outright at perceived tops, it is a far more prudent strategy to ratchet up your trailing stop losses to a tighter percentage. That way you will be stopped out with more of your gains if the top really materializes, but if gold shoots higher still you can stay along for the ride.

Second, the best way by far to add new positions is to scale in on success. Say you want to buy gold because you think it is going up after a perceived major interim low. You figure out how much capital you want to bet on gold but you don't deploy it all at once. Instead you might divide it five ways and first deploy only 20%. If you are wrong, if the gold price drops, you don't risk any more capital because your thesis was flawed. But if you are right, if gold goes up, you can buy another 20% of your position. And if it keeps going up, you scale in the rest of your trade over a few weeks.

Scaling in on success minimizes the risks to your capital early on when a new trend is most uncertain. You are testing the waters with a small portion before you fully commit the total amount you intend to. Interestingly, the interaction of rGold and the MACD as a binary indicator create a system that is highly conducive to practicing this scaling-in discipline near bottoms.

On with the narrative, gold reached its third major interim top in January 2004. On the very day gold topped, rGold closed at 1.153x. This level is important because it is above the rGold topping range that we were watching at that time of greater than 1.11x. Gold initially broke above 1.11x relative about five weeks before this top. Since gold had run up to this level, it alerted speculators that the probability of a top was growing. So they could have tightened up their stop losses in advance and prepared to get stopped out if the correction really materialized.

Indeed it did. Gold continued higher until early January but traders would have still held their positions since they just ratcheted up stops and didn't sell outright at the initial signs of rGold being overbought. And once gold started to fall, they would have been gradually stopped out. But they wouldn't have known for sure a correction was upon them until the MACD turned negative. Its slope rolled over 8 days after gold's top. After that secondary confirmation provided by the MACD rolling over, they could be pretty convinced that gold had indeed topped and a correction down under gold's 200dma was in order.

Working together in this case rGold and the MACD provided good initial warning and secondary confirmation of a major interim high in progress. The next major interim reversal, gold's fourth major interim low, also worked quite well to alert speculators and investors to gold's bottoming in progress.

Gold bottomed in May 2004, and back then an rGold level under 1.02x was considered a buy. This level was achieved about three weeks before gold's actual interim low. Crossing this threshold alerted speculators that gold should be nearing a major interim low. Traders could have continued watching gold approach its 200dma and even scaled in an initial small exploratory position. Soon after, rGold bottomed at 0.953x. Once the rGold trend started higher again, scaling in could be continued.

And then 35 trading days later the MACD itself bottomed and provided strong confirmation that gold was indeed in a new upleg. Once this confirmation was in place, speculators and investors could continue buying gold and scale into their positions even more aggressively. rGold lows had alerted them to the coming gold low and the subsequent slope recovery in the MACD a little later confirmed the lows.

So to use rGold and the MACD as a binary integrated trading system, here is the general principle. First establish a horizontal high-probability rGold trading range. Today ours at Zeal runs from less than 0.99x on the gold bottoming side to greater than 1.14x on the gold topping side. Then when these rGold boundaries are first hit, start watching both subsequent rGold extremes and the slope of gold's 50/200 MACD. As soon as rGold starts to turn around after exceeding the edge of its range, odds are a reversal is here.

At this point speculators can really tighten up their trailing stops if near a top or start gradually layering in if near a bottom. But traders can't really know for sure that a major interim top or bottom has really been carved until the MACD slope rolls over off a top or recovers off a bottom. Once this happens the new intermediate trend is considered confirmed and trades running with it can be aggressively added.

This is especially helpful on the buy side since gold tends to consolidate near lows when it is bottoming. Between rGold that tends to bottom just under 0.99x and the 50/200 MACD which has been turning near these levels as well, the primary signal and the secondary confirmation give traders a high degree of confidence that a bottom has been carved. Indeed this is exciting today as the MACD seems to be ready to turn north soon here confirming the recent early October gold low as a major interim bottom!

The top side of this trading system is more problematic due to the nature of bulls to surprise to the upside. The key case in point is early February of this year when gold seemed to top. It carved a lofty rGold high above 1.23x, the highest of its bull, and its MACD even started turning lower a month later. It was definitely a topping signal per this system. But false top signals are not that big of deal thanks to trade management.

Since tops in bulls can be far higher than anyone expects when people get excited about a rallying price, traders shouldn't generally sell outright anyway. By being aware of a probable top though they can ratchet up their trailing-stop percentages to ensure they preserve more of their gains if a correction really ensues. But if it doesn't, even the tighter stops generally allow them to remain in their positions long enough to catch the next ascent of an upleg if it isn't over yet. So while tops are more ambiguous, stop losses address this concern.

The thing that really interested me about this system this week in particular was the position of gold's 50/200 MACD today. As you can see in the chart, this key secondary confirmation indicator seems to be poised to start turning upward any day now. We had a deep rGold low in early October and now the MACD is on the verge of confirming this low. This means we have a high probability that the gold bottom is in and we are in the early days of the next major upleg in gold.

At Zeal we've been watching this carefully all summer and started layering in gold stocks and gold/base metals hybrids back in late September near the rGold low. Most of these trades are now thriving, with unrealized gains in this short period of time already exceeding 30% in some cases. We are continuing to layer in new gold, hybrid, and base-metals stocks and they ought to do exceedingly well in the coming months if these indicators prove right yet again.

If you want to see our new trades as we make them and gain the opportunity to mirror them with your own risk capital, please subscribe to our acclaimed monthly newsletter today. We hope to continue layering in new trades as long as market conditions permit. Bull to date such amazing opportunities as major interim gold bottoms have only materialized about once a year on average, so it is really important not to miss them. Since gold is the primary driver of gold stocks, near these gold lows is the best time to buy gold stocks too.

The bottom line is gold can be successfully traded using a combination of moving-average-based approaches. The primary advantage of moving averages is their slow speed forces traders to be patient and wait for sentiment to change favorably. The equal weighting across a moving average also overrides our natural tendency to get caught up in today's news rather than keeping gold in proper strategic perspective.

While it has been a hard summer in gold, the moving-average tools I described above suggest the worst of this correction is probably behind us. Gold appears to be bottoming and a relatively rare major buying opportunity has been triggered. Soon the MACD will likely confirm and we ought to be off to the races.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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