Wednesday, July 27, 2011

Anatomy of a Technical Trade

By Scott Silva
Editor,  The Gold Speculator

One of the laws of market espoused by those that embrace the efficient-market hypothesis states
“Stock market prices are unpredictable.”  Technical analysis, however, has proved effective at predicting future price direction through the study of past market information, primarily price and volume. To be sure, predicting future prices of a stock or commodity can be challenging, and not always successful, but the speculator can profit from correct technical analysis of a traded good. The price movement of silver over the last eleven months provides a good example. So let’s examine the anatomy of a technical trade in silver.

One of the most liquid markets for silver is the market for silver futures, traded on the COMEX.
Other markets for silver include exchange traded funds, or ETFs, which trade similar to stocks. Price and volume history for each type security are readily available, which allows the technician to work.

The technical analyst searches for chart patterns that develop with price action over time. Volume associated with price action is an important factor in evaluating the validity of a particular chart pattern. Independent indicators can also help confirm the validity of the primary pattern. Back in September 2010, we identified a breakout pattern in COMEX silver that predicted a bullish move up. We saw this play out in higher silver prices since that prediction. 

Here is what we observed on September 3, 2010:


                As we survey the various elements of the precious metals group in the run-up to Labor Day, it becomes very clear that something big is brewing.  As we see, the chart of silver has formed an ascending triangle going back to Dec. ’09.  This triangle has broken out today, and it presages breakouts throughout the precious metals group. Using the semi-log continuation chart ( we can predict the price objective for silver at about $60 using the present data.

Technical analysts know the ascending triangle pattern is a bullish formation that usually forms during an uptrend as a continuation pattern. Although there are instances when ascending triangles form as reversal patterns at the end of a downtrend, they are typically continuation patterns. Regardless of where they form, ascending triangles are bullish patterns that indicate accumulation. The length of the pattern can range from a few weeks to many months with the average pattern lasting from 1-3 months. As the pattern develops, volume usually contracts. When the upside breakout occurs, there should be an expansion of volume to confirm the breakout.

We use the ascending triangle pattern to calculate the price target by projecting a line parallel to the ascending trend line (bottom trend line) starting at beginning of the horizontal resistance line, and extend it to intersect the price scale. This can be seen as a mirror of the ascending triangle with a common horizontal base. Care must be taken to account for semi-logarithmic price scale. For COMEX silver, the September 3, 2010 breakout from the ascending triangle pattern produced a target price of $60/oz.

We recommended subscribers buy COMEX Silver at $20.78 on September 17, 2010.

Price action in November and December produced bullish pennant patterns that confirmed the continued move up for silver. The chart below was explained to subscribers on December 10, 2010.

       The key technical formation of the moment is the pennant which formed in silver over the month of November.  Silver did move into new high ground early in December.  But it fell back and appears to have met support at the $28-$29 level. The November pennant gives a point count to $40.  There was a 61% move in silver from late August to early Nov., and the pennant predicted an equal (percentage) move.  A 61% rise from $25 gives us a target price a touch over $40.  Our objective for silver at $40 is mid February (on the argument that the second leg out of the pennant will be equal to the first leg in time).

We know that commodities, including silver correspond to movements in the Dollar. This makes sense since silver is usually purchased in Dollars. So when the Dollar weakens, the same ounce of silver commands more Dollars in exchange. Likewise, the strong Dollar buys more Troy ounces (31.1034768 grams) of silver. Hence, silver usually has an inverse relation to the Dollar. It is important to recognize that the price movement of one does not cause the price movement of the other. Prices rise when there are more buyers than sellers for a particular good. The value of the Dollar decreases with increases in the money supply.  The technical analyst can use these facts to his advantage in predicting future price movements.

We can see the inverse relationship between the Dollar and silver in the chart below.

We saw the Dollar drop steeply in September-October 2010. This corresponded to the first large leg up for silver over the same period.  In December we recognized a bearish pattern (head-and-shoulders top) on the Dollar index that broke to the downside for the next five months. This corresponded to the second large leg up for silver over the same period.

Here is what we told clients about the Dollar on December 15, 2010:

Here is the weekly basis chart of the US Dollar.  Notice that the chart gives the clear head-and-shoulders top. This formation has to dominate our thinking on the intermediate term.  A breakdown from the neckline predicts a drop to 74 or lower.  We can expect commodities to benefit on the Dollar decline.

We saw silver continue on a parabolic rise on its way to $60/oz. At $50/oz, the CME slammed the door on buyers by raising margin requirements to 50% of position value. Retail buyers who got in late bailed out, or were called out on margin. Since then, silver has made a return to over $40/oz as investors return to silver and gold as the debt crises in the EMU and the US unfold.

Today, silver and gold have reclaimed milestones. Gold is trading over $1600/oz and silver is trading over $40/oz. The Dollar is selling off, just a point away from its May low of 72.86.

Resolution of the US debt issue is likely to reverse the Dollar’s slide, and pressure gold and silver. But the US debt issue has devolved into a day-to-day melee; Congress and the White House may not be able to control the situation before the credit agencies take action. One thing is certain- downgrade of the US sovereign debt would be catastrophic for the markets here and around the globe.

So, how should the prudent investor be positioned today? Technical analysis helps show the way.

Investors from around the world benefit from timely market analysis on gold and silver and portfolio recommendations contained in The Gold Speculator investment newsletter, which is based on the principles of free markets, private property, sound money and Austrian School economics.

The question for you to consider is how are you going to protect yourself from the vagaries of the fiat money and economic uncertainty?  We publish The Gold Speculator to help people make better decisions about their money. Our Model Conservative Portfolio gained 66.7% in 2010, and 55% for 1Q2011. Subscribe at our web site  with credit card or PayPal ($300/yr) or by sending your check for $290 ($10 cash discount) The Gold Speculator, 614 Nashua St. #142 Milford, NH 03055

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