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TraderSavvy Newsletter for Futures Traders
In This Issue:

Chad Butler of RJOFutures takes a look at the Gold futures market: should you trust the longer-term trend and buy dips, or sell the rallies?

May 2, 2007   |   Read Past Issues
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Complimentary Guide:
The Basics of Money Management"

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What's Next for Gold?

A mere matter of months ago, everyone was clamoring to get on board the gold train. Then, without warning, the market made a hard break and took out many weak longs with it. So, where are we now? Should you go with the longer-term trend and buy dips? Or is it prudent to be selling rallies?

Some of that depends on you as a trader, but overall, the general approach to this market is the long side (at least for now). True, Gold is at historically high levels, and markets don’t go up forever. But let me give you an analogous market situation - Internet stocks of 1998. Quite a few traders saw the ridiculousness of those stock valuations. They did the only thing that made sense in that scenario – they shorted the market. But a lot of them were forced to throw in the towel long before the market peaked in 2000. Gold is high now, but how high would you be willing to let it go before you threw in the towel? $800? $1000? $1500/ounce? The truth is we don’t know how high it will go. We just know that the trend is our friend (until the end).

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Before we can trade this market, we need to determine the trend (so we aren’t on the wrong side of it). I like to do that using some simple moving averages and an exponential moving average. To me, the relationship between the 9 period and 50 period simple moving averages is key to determining trend on daily, weekly, and monthly charts; and that for long-term trend trading, the relationship between these three time periods is also key.

Let’s look at the 9MA and the 50MA on the August futures daily chart. The 9MA, representing the short-term money pressure on the market, remains above the 50MA, which represents the long-term money pressure. Until the 9MA crosses below the 50MA, this situation is bullish. However, these indicators for me do not exist in a vacuum. Other critical pieces of information are needed to tell the whole story.

Chart provided by RJOFutures Research

I also consider the 20 period Exponential Moving Average, which gives more weight to recent days’ activity than those farther in the past. As you can see from the chart, we settled below the 20EMA on April 26th. A long entry for us would be a recapture of (settlement above) the high of that day. If that occurred, the stop would be below the low of that day. There is currently support in that area from the 50MA as well.

The daily chart is indicating that we need to be long gold, but I am not one to jump into the market without confirmation. We have to hold back here just a moment and say we need confirmation on the daily chart in order to be in the market. I’ve marked the 703 area as a key price area on the chart. There is some concern that this wasn’t broken in April, but markets do not always break through resistance on the first attempt. So, while that fact alone would not cause me to change my stance to bearish, I will be watching the daily chart closely.

Breaking through this resistance area should give some momentum past the psychological $700 barrier. A breakout of $703 would not only be a breakout of resistance, it would also likely pull our other indicators to be strongly bullish. There is room to use a lower price based on the 20EMA setup discussed earlier if you are more aggressive.

My usual method of market entry in trend following is to buy on a stop, and if filled, I would place a sell stop in case we are wrong and do not get follow-through buying. Where exactly to place the stop is a matter of your personal risk tolerance; there is no one right place. There is, however, a very wrong way – using an arbitrary dollar amount. That is a critical mistake make by a great many traders. Using $500, $600, $1000 as your risk has nothing to do with the technical areas on the chart and this method of stop placement often results in locking in a loss.

Instead, let the market determine your stop. (And if the key price levels are too large for your risk tolerance or account size, you should stay out of that market. In terms of gold, there is also a smaller contract at the CBOT you can use if you fall into this category.) Some key areas I would look at would be 680, 675, and 650 (these are general price levels basis the August futures; you need to look at the month you are trading for specific support/resistance levels and prices). Remember, this is a volatile market with some very large swings. I cannot emphasize enough that if you can’t stomach that big of a swing, you should consider another market.

On the upside, our initial profit target would be a breakout of February highs to test last spring’s highs. Depending on how the market reacts (if we go there) will determine whether I would look for it to push through or if I would take profits. We need to wait until we get there to make that call.

So we have our market outlook, a trade setup, our risk control, and an initial profit target. As I said before, if the risk in the futures is too great, you might want to consider another market. If that is the case, I would recommend looking for potential option spread opportunities.

No matter how you choose to trade this market, you are going to need a sound plan. A sound trading plan must include a strategy for money management and risk control. That is why this week I am offering a free copy of “The Basics of Money Management.” This will help you determine a sound strategy for stop placement, determining appropriate capitalization, and how to manage your risk exposure.


About Today's Author:

Chad Butler is a Senior Market Strategist with RJOFutures, a division of R.J. O'Brien. His 16 years of market experience includes option spread trading, diversified trend following, and development of a number of index arbitrage programs.

Chad’s published work appears in McGraw-Hill's Complete Guide to Single Stock Futures, Futures Magazine, and other trade publications. He currently writes for various commodities newsletters, including RJOFutures MarketNews and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.

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