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Each
commodity and each economic good has its own characteristics, and before you
trade any market seriously, you should stick your toe in the water, so to
speak, (meaning to trade at a level you can afford). In this way, you
can acquire knowledge of the characteristics of the particular market.
I
do not recommend paper trading because any market has a way of grabbing hold
of your emotions and making you do things which you would not do under the
perfect conditions of an academic study (where there is no money at stake and
no time pressure). Most people in the markets are acting on their
emotions, and if you want to take their money, then you must be in control of
yours. And the best way to learn to do that is to trade with your own
money (but always an amount you can afford to lose).
Indeed,
this experience in controlling your own emotions is so important that it
applies to those around you (who are supposed to be on your side). Very
often a giant emotion will dominate a market. This emotion becomes so
strong and so universal that it is very hard to take a position against
it. But when I had gotten to the point where I had mastered this, I
found that there was another trap. I kept running into a series of
mistakes on the part of the people around me because they had succumbed to
the prevailing emotion and were not properly executing my orders.
Of
the various technical theories on the markets, my criteria for deciding which
ones to use is based on what works. And I have found the best results
with the chart patterns
described
in Technical Analysis of Stock Trends by Edwards and Magee.
These are simple, geometric patterns with forecasting implications.
When one of them appears, it is usually reliable but not perfectly.
(Edwards and Magee say they work 70% of the time.) For this reason, I
try to increase my probability of success by finding 2 corresponding patterns
in goods known to move together.
For
example, consider the ascending triangle which formed in gold from March
’08 to October ’09 and broke out thereafter. Let us give
this a 70% chance of hitting its price objective line (which is the line
drawn parallel to the bottom line of the triangle and going through the upper
left hand point). The price objective line is rising very
rapidly. If gold hits it next spring, it will be at $3,300. If it
hits it in spring 2012, then the price will be between $4,500 and
$5,000. Since this number is very high, it has the quality of
too-good-to-be-believed.
However,
we are now getting another ascending triangle in the HUI. The only difference
is that the triangle in gold broke out last October while the triangle in the
HUI looks ready to break out in a matter of weeks. If it does, then we
can compound probabilities as follows. The probability of failure in
gold is 30%. The probability of failure in the HUI will also be
30%. It is like the math problem of flipping a coin twice and asking
what is the chance that you will lose both times.
Our
chance of losing both times in the markets is (1 - .70) x (1 - .70) = .30 x
.30 = .09. Thus our chances of being wrong are only 9% instead of
30%. If we can find another good chart pattern in a related good (say,
silver), we could multiply our probability even more. If silver breaks
out of a corresponding triangle, then we have .30 x .30 x .30 = 2.7%.
That is, our chances of being wrong will be less than 3%. And those are
good odds to play.
All
bullish chart formations must be confirmed by increased volume on the
breakout. Bearish formations do not need volume confirmation.
(Stocks need volume to rise, but they fall of their own weight.)
Almost
all chart patterns have price objectives attached to them. This tells
you how far, at a minimum, the economic good will travel before
reversing. For a triangle, the price objective is not a point (as it is
in most cases) but a line. Before the chart reverses, it will reach the
price objective line. This means that the slower the chart moves the
higher it will go.
Below
we have a symmetrical triangle which formed over the middle part of 2009 and
broke out in September. Notice how gold reached the price objective
line of this triangle in November, and this was an important clue for my call
of an intermediate reaction in gold in early December. A price
objective or price objective line is always a minimum. This means that
the good has to at least reach this point. When it does, there is
usually an intermediate (or short term) reaction. And then the good may
continue up to a higher level.
Above
we have a head and shoulders bottom in gold extending from December ’09
to late April ’10. Its name comes from its shape, which is that
of a man’s head and shoulders turned upside down. (There is also
a head and shoulders top, which is rightside up). The line joining the
two high points is the neckline, and the formation is complete when prices
break above the neckline (a little above $1,160, in late April). Notice
that the $80 price break in gold of mid-May was a very nice return to this
neckline (which has now become support).
To
get the price objective on a head and shoulders bottom, we measure the
distance from the bottom of the head to the neckline (on a semi-log
chart). The distance from the bottom of the head to the neckline is
10%. Projecting a 10% rise from $1,162. We then measure upward
from the neckline at the point where the price action crosses above it (also
$1,162). This gives us an objective of $1,281. If we use the
electronic gold chart, which records trading overnight, the calculation is
close to $1,300. So this objective has not yet been reached.
Gold
is a good chart commodity. It forms chart patterns frequently, and they
are reliable. I mean to show by this study that good technical analysis
is not too difficult for the average person. Quality (recognizing the
patterns and applying them correctly) is more important than quantity
(knowing a large number of patters) for the reason that a few, simple
patterns tend to repeat. You must take some risks in trading, but if
you stick out your neck too far, you will eventually get it chopped
off. So limit possible (worst case) losses to 3-6 months of income or
20% of capital.
As
a teaser, I will leave you with a final chart pattern, which completed on
Friday. Try to identify it and see if you can calculate its price
objective. (Hint, you will need to print out the computer image on
paper and complete work with pencil and ruler.)
Howard Katz
The Gold Speculator
Howard S. Katz is
the editor/publisher of the One-handed Economist, a financial letter which
combines fundamental and technical analysis. He was a bug on gold in the 1970s
and became a bug on gold again in late 2002.
Subscribe to the Gold
Speculator (the One Handed Economist)
You can subscribe
to Howard Katz’s thoughts on commodities, stocks, bonds and real estate
are available in a letter entitled The One-handed Economist and published
every two weeks giving specific advice on trades in stocks and futures. This
letter is available (both electronic and paper copy) for $300/year with a
3-month trial for $100. Send to: The One-handed Economist, 614 Nashua St.
#122, Milford, N.H. 03055.(Include both electronic and mailing address.)
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