by Joe T » Mon Aug 23, 2010 1:05 pm
Step 6: Set your price safety level
This is where money management comes in. How risky do you want to be? With higher risk comes the possibility of a higher reward. However, higher risk also increases the odds that you will blow your account. Everything’s a balance.
One micro-lot represents one ounce of gold. You can eliminate leverage altogether by setting aside capital equal to the price of gold and buying one micro-lot. If you do this, it’s basically the equivalent of buying a gold coin, except that you can liquidate in the Forex market more easily than you can liquidate your physical gold. (There may be other advantages to physically holding gold, but that’s a completely different discussion from a trading strategy for the purpose of making money.) This is the absolute least risky way of doing it, because it guarantees that you will never run out of capital unless gold is someday worth $0. But you realistically wouldn’t expect that, and so you don’t need to go that far.
The next most conservative route to take is to assess the absolute lowest potential price that the most bearish person on gold would give you. There are a few ways we can look at price and try to determine some of these points for ourselves.
Historically, gold price was suppressed due to currency pegs, but since the 1970s know the free market values associated with it. From 1970 to 1981 we saw a dramatic run-up in price, and then we saw things settle back down. The lowest nominal market price since that all shook out occurred in 1999, at $252.80. If you assume 3% annual inflation since that period of time, we’re looking at a price point of about $350. This low point in gold price came about as a result of extended economic growth, and was 20 years in the making.
Since there is no reasonable expectation, given the state of the world and economy, that price would plunge down to $350 tomorrow (or within the next year), there are a few other ways we can probably evaluate a current safe zone for our current trading period. One thing we can look at is the last time we saw a historical run-up in gold price. In 1980, price hit $850/oz. The low point in 1981 reached $391.25. That is a decline of 54% from the high. We could look at the current high-point of $1265.05 and calculate that the low could hit $582 in the next year or two if a similar thing occurs. (I don’t think it will, because the current run-up looks different from that one. But you never know.)
We can also look at recent resistance to see where it may fall. If I pull up a daily chart, resistance levels from the last couple years show the following levels: $679 (10/2008); $699 (11/2008); $741 (12/2008); $801 (1/2009); $864 (4/2009); $904 (7/2009); $925 (8/2009); $984 (9/2009); $1026 (10/2009); $1044 (2/2010); $1084 (3/2010); $1156 (7/2010).
We can also look at the 50% retrace level from low points to the maximum. From the 1999 low of $252.80 to the maximum, a 50% retrace is $759. Other potential 50% retraces might be the run from $679.55 (10/2008) to $1265.05, or $972.30. Or, from $864.50, with a retrace to $1,064.78. Most recently, from $1,044.05, with a retrace level to $1,154.55.
We can also look at trend line support. Trend lines as of today look to have support levels at levels between $1170 and $1175.
So, there are a number of ways you can look at this. The entire point of establishing your target is to understand what it means. It means that if you buy according to plan, your entire account will go to zero if gold reaches that price. Therefore, you want to select a price that is low enough so that you are fairly comfortable that this will not happen. Or at the very least, if you take an aggressive approach, you fully understand the chance you are taking, and have nobody else to blame if the market goes lower than your safe target.
I offer no recommendations to anyone on this selection, because it is a matter of personal risk preference. I will simply tell you what I have done and why. In saying this, I fully understood from the beginning that I was taking certain risks, and will accept all the consequences of my decision.
When I started, I traded this very aggressively, in that my zero-account price was almost $1000. I started with only $2300 in capital, and my own judgment was that once gold got over $1000 in the prevailing economic climate, there was little short-term risk in it falling below $1000. I knew that I didn’t want this to be my long-term target, but I wanted to build up some capital. As I took profits, I lowered my target. I did this more quickly the first couple months to preserve capital.
Then, for a few months, I lowered my target by $5/month, until I got down to $950. I was able to absorb much of this by using profits to lower my target without dramatically changing the aggressiveness of the approach.
I had a decision to make when gold soared to new highs. Because new highs reset my buy-in points, there are more such points to consider. This means that I either need to (a) maintain my current zero-balance target level and reduce lot sizes, or (b) maintain my current lot sizes and increase the target level. I chose at this point to keep the zero-balance target where it was, so I became more conservative with the trading approach.
Once I reached $950, and considering the price level of gold and all the different resistance, 50%, and trend line points between current price and that zero-balance level, I am now continuing to lower that target, but much more slowly. I use realized profits to adjust the target, will not lower it more than 0.5% in any given month, and will further adjust it upward slightly at the end of the month to increase the lot sizes ever so slowly.
I currently have a targeted zero-balance price of $943.78. Depending on how you view history, this is either fairly safe or pretty risky. It is risky in that price was below this level as recently as 08/27/2009. It is safe from the perspective of most recent-year 50% retrace points. It is risky in that the inflation-adjusted lowest gold price in the open-market era is about $350. It is safe if you look at current economic indicators on a global basis, and the fact that it’s below that really nice round numbers of $1000 and $950. It is safe in the respect that the last 5 major support levels need to be pierced to reach it, but it’s risky in that there are other support levels beneath it established within the last couple years. It is safe in that we’ve had a very clear and solid linear trend line that is established over $200 above this level. It is risky in that trend lines can become resistance levels if pierced. Each person has to weigh the pros and cons and select a comfort level accordingly.
The implication of setting your safe target is that, for a given amount of capital, your plan of trading is limited to lot sizes at buy points so that you do not run out of funds prior to hitting that level. This means you are continually looking at your plan and the impact of your plan based on your target zero-account price. We’ll get to setting that up so it can be evaluated properly. It doesn’t take long to do, and only needs adjusting as you take profits, and thus add capital.
For now, you simply need to do the following on your spreadsheet:
In F15 type “Target Price @ Zero Balance:”
In F16 type “Current Balance:”
In H 15 enter your target zero-balance gold price, after thinking everything through and assessing your risk tolerance.
In H16 type in your beginning capital. Your capital will be adjusted as you realize gains and losses. (Capital does not account for unrealized losses, because the spreadsheet already calculates those. So you are not entering equity, but instead your balance.)
Note: Depending on your platform, you may actually realize losses due to First-in-first-out requirements, but don’t fret about that. It will make tracking things a bit more difficult, but it gets you to the same spot. My MT4 platform displays trades the way I prefer – as if I’m trading in and out of the same position in isolation. But my actual account actually sells the oldest positions first, and all my transactions are grouped, averaged and presented as a singular entry price, so I may show a realized gain/loss on MT4 for a given trade that I closed while it shows the other way on my account. That’s not a problem at all, because it means a different position did or will show a higher profit when it closed. You should use the capital balance on MT4, and not from your account statement, because this reflects your actual trading patterns. It does make reconciling the two more annoying, but it’s nothing that can’t be dealt with.
The discussion above relates to long positions. Since I short gold at higher prices, then I also determine a zero-balance target on that as well. My current safe price on the upside is $1513.97, which includes three old shorts from a previous strategy that are well in the negative.