Don’t Catch the Falling Knife

It’s been a wild ride in the metals markets. After gold lost more than 15% in just three days, many are wondering – what’s next!?

No one knows for sure, of course. But let’s examine the possibilities…

First, the obvious – gold could go up, or down, from here. We expect it’ll go up in the short-term and down over the long-haul.

Sharp, sudden selloffs like we’ve just seen are typically corrected to some degree. Watch for a dead cat bounce off of $1,350. Staunch gold bulls will be looking to buy in at these now “cheaper” prices. Gold sellers will take a break, cashing in on short-term profits from short positions.

How long, and how high, the bounce will be is the next question…

It could be extremely mild, say to just $1,425 or so. This would put prices at the 38.2% Fibonacci retracement of the three-day slide.

A deeper, 61.8% Fibonacci retracement puts gold prices back up to $1,475… so it seems likely gold will at least test this zone on the way up before rolling over again.

On the high end of my target is $1,550. This is the oh-so-important level from which gold’s plummet began. As this was once an important support level, now that it’s broken we can expect it to act as resistance.

The ideal trade, in my eyes, is to see gold drift back up to $1,525 or $1,550, form a low-volume rounding top, and then fall hard once again.

That said, this is a dangerous trade to get involved in. Trying to buy gold now is a classic example of trying to catch a falling knife.

One way to play this move is with a spread trade. That means buying gold and simultaneously selling a related investment, like 30-year bonds, for example. Here’s a chart of the ratio between gold futures and 30-year bond futures.

See larger image

This ratio – gold/bonds – has obviously tanked in the last week. The ratio will revert to its average, meaning gold prices will increase and bond prices will decrease. Or, at a minimum, gold will increase more than bond prices increase.

This spread approach is not without risk, but it sure beats trying to catch that falling knife and risking your fingers!

Adam O’Dell

Using his perfect blend of technical and fundamental analysis, Adam uncovers investment opportunities that return the maximum profit with minimum risk.