Tuesday, April 16, 2013

Gold futures break above a very bearish channel

APR16 0846EST. As everyone knows, gold futures (along with silver and crude oil, among other) have experienced a savage decline since Friday, Apr 12. Over the past three trading days, the yellow metal has declined from a high of around $1560 to an overnight low last night of $1321.50, a decline of just over 15 percent.

GCM3 (Gold futures contract, June 2013 expiration). Fri, Apr 12, 2013 to Tues, Apr 16, 2013. 5-min candles.
Among the interesting stories to tell about this price decline is its remarkably close adherence to a simple price channel, shown above with grey dashed lines. Almost to the tick, the channel's upper boundary connects three prominent local maxima and, with its parallel lower boundary, perfectly connects two local minima. Meanwhile, the other local minima of the decline all stop just above the channel's lower boundary.

Why does this matter? For one, consider the channel as a simple model of the extremes of market participants' collective psychology. As price approached each of the local minima, a frightening chaos was breaking out: price decline, already very severe, was accelerating further; terrified longs were reaching their maximum pain point, often in the face of margin calls and even complete account blow-ups; jubilant shorts were jumping in with ever more enthusiasm. Yet in the face of all this momemtum, all this money, all these hormones, price action at 9:55a CST on Monday, Apr 15 stopped at $1356.6 -- the lower boundary of the channel that had been created over the prior 24 tumultuous hours.

Moreover, consider how the channel was further validated once price action became poised to break through the upper boundary, which occurred around 22:00 CST on Monday, Apr 15 and, in the screenshot above, is circled in yellow. Even at its demise, the channel exerted an influence, repealing bulls twice -- notice the two topping tails within the yellow circle, each highlighted by a vertical red line. Then, just before bulls broke through the channel's upper boundary, price consolidated horizontally for a few candles just below the boundary line -- this price action is highlighted above by a horizontal red line.

Again, why does this matter? Let's once more remember that the channel was well-defined in both life (when it modeled local maxima and minima almost to the tick) and death (when price action paused and briefly consolidated before breaking through). Given this, a high-probability trade idea was born on the bullish breakout from the channel: namely, to take a position in the direction of the breakout, with a well-defined stop-loss point on a reaction back into the channel.

To be clear, this analysis says nothing about where the GCM3 contract will trade next week, or even tomorrow. A trade like this is just a test of a hypothesis: will the breakout hold or fail? There is no implicit judgment about where the security is ultimately headed or ought to be.