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In This Issue:
Chad Butler discusses the Gold market, with a primary focus primarily on technical analysis.

June 6, 2007
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A Technical Analysis of Gold

Today’s article will focus specifically on the Gold market, in the scope of this larger cycle. Since this article would not provide enough space for us to dissect the bullish scenario of the market based on fundamental analysis, we will focus primarily on a technical analysis approach. By doing so, I think this offers a little something for everyone—gold traders, market technicians, trend followers, and maybe even a little something for the fundamentalists and market psychologists.

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?

Well, some of that depends on you as a trader, but overall my opinion is to approach this market on the long side. 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? $1,000? $1,500/ounce? The truth is that we don’t know how high it will go. We just know that the trend is our friend (until the end).

(continued below...)

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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 a moving average convergence/divergence (MACD) that complements those moving averages (MA). To me, the relationship between the 9 period and 50 period simple moving averages is key to determining trends on daily, weekly, and monthly charts—and for long-term trend trading, the relationship between these three time periods is also key.

Beginning with the August contract, let’s look at the 9MA and the 50MA on the daily. The 9MA, representing the short-term money pressure on the market, is currently below the 50MA, which represents the long-term money pressure. This situation by itself is bearish. However, these indicators for me do not exist in a vacuum. Other critical pieces of information are needed to tell the whole story.

Chart © Copyright 2007 FutureSource

I also consider the 20 period Exponential Moving Average (EMA), which gives more weight to recent days’ activity than those farther in the past. In the case of the daily chart, we have recaptured the 20EMA, an important technical level. The second factor I need to consider is my MACD. Here we have the MACD crossing over, which indicates a possible momentum shift to the upside.

Before getting excited, we need to stop and take a look at the longer-term picture. If we are looking to enter the market in a trend-following trade, we need to know if we are in line with the longer-term trend. To do that, I look at the weekly chart.

Chart © Copyright 2007 FutureSource

One key thing we notice on the weekly is that the 9/50 MA relationship is bullish (the 9 period MA is above the 50 period MA). Another, probably more important key is that the market broke the 20 period EMA, then very quickly regained that area. This indicates a technical rejection of lower prices and is a signal to be looking for areas to buy the market.

The daily and weekly charts are indicating that we need to be long gold, but I am not one to jump into the market without confirmation. I would like to see the market close above the high of 6/1/2007 when we recaptured the 20EMA. That would mean a settlement above 677.50. That should set up a test of the 50MA and possibly the high of the current range in the 705 area. Trading to 705 would definitely pull our 9/50MA relationship bullish, and a breakout above that should set up further buying.

 Where 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 made by a great many traders. Using $500, $600, $1,000 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, which you can use if you fall into this category.) Some key areas I would look at would be 657.50 and 647.20. Now these might be a little aggressive, but this is now 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 run to the old 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. 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 or use a limited risk option strategy.

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.