Ok, now the headline of this article implies that I am “predicting” that the price of gold is “about to rise”. Which is interesting, because just last week I went on a bit of a self righteous rant about how pointless it is to make predictions.
So what gives? Am I suddenly able to see the future and what is in store for the financial markets? Not hardly. Am I a self-righteous hypocrite? Just never you mind about that. In fact, the real point here is that there is an important difference between “making a prediction” and “weighing the evidence” and taking action as a result. Let me explain this important distinction.
The Problem with Making Predictions
When a person “makes a prediction” regarding what lies ahead in some segment of the financial markets, typically he or she tends to adopt some sort of emotional attachment to said prediction. This can be a big problem. Because let’s face it, if you make a prediction and you turn out to be wrong you feel (and look) pretty stupid.
If you’ve watched the financial market shows on TV or cable you’ve likely seen this happen. Someone will lay out the case as to why such and such a stock or commodity “just has to” advance in the next x number of days, weeks or months. If things moves sideways or slightly against them for awhile then the next time you hear from them they “pound the table” a little harder, even more insistent this time than last that they will ultimately “be proven right.”
And in the end, maybe this time they will be or maybe they won’t. Like it matters to anyone but them. The bottom line is this: once your ego is attached to rooting for a certain outcome, the danger increases exponentially. This is simply because once your ego is involved, the primary focus becomes being able to say "I was right.” This is what causes investors to hold onto a losing trade for too long.
The financial markets being the wicked beast that they are, the more you insist on holding on until you are right, the more likely this is the time the position will go against you hard. Consider...
So what’s the alternative? As dispassionate an approach to investing.
A Better Frame of Mind
Jay’s Trading Maxim #177: If you had to choose, in the long run you are better off with an attitude that states that “every trade is just as meaningless as every other trade” than you are thinking that every trade is going to “be the big one.”
While a very strong wind may get your boat to shore more quickly, there is also a much greater risk of an adverse event. Given a choice, a sailor will typically prefer relatively calm seas to a full force gale. For most of us the same is true in trading. In a nutshell, if you approach each trade as “just another day in the office” so to speak, you reduce the tendency to become emotionally attached to a given position or market outlook.
So How Are We Supposed to Trade Without Predicting What Will Happen Next?
This is a good time to remind you of the crux of the Optionetics approach as laid out many times by George Fontanills and Tom Gentile is as follows:
1) Identify an opportunity
2) Find a trade to take advantage of that potential opportunity (preferably without risking your shirt)
3) Manage the trade
Now the phrase “spot an opportunity” can mean a whole lot of different things to different people. But for now simply make a mental note that there is a big difference between the phrase, “spot an opportunity” and the phrase “accurately predict what will happen next.”
The latter phrase suggests that you should only invest money when you are “certain” that you will be “right” – even though most will readily admit that there is no way to ever be certain.
The former phrase is basically short for, “find a situation where based on some reasonable, objective criteria you think there is a better than even chance that the security in question will go in the direction you expect, so as long as you are willing to risk only a reasonable portion of your capital, and as long as you are willing to cut your loss if you are wrong, without suffering a bruise to your precious ego then it makes sense to go ahead and enter an actual position in order to have the potential to make some money if the opportunity works out as you hope.”
(So for obvious reasons you can see why this was cut down to simply “spot an opportunity”).
Spotting an Opportunity
Lots of technical traders look at something known as the Elliott Wave to help them identify potential trends in the financial markets. While a detailed explanation of Elliott Wave is way beyond the scope of this article, in a nutshell, the theory is that markets advance in 5 waves – 3 up and 2 down, and then decline in 5 waves - 3 down, 2 up. Sounds a little “exotic” I will grant you – and there is of course that pesky problem of objectively identifying which wave is presently in force. Still, while I am not a dyed in the wool “Elliott Head”, I do look for situations when the weekly and daily wave counts are both projecting Wave 5 advances.
Now if you know little to nothing about Elliott Wave than your most likely response to the last sentence was “huh?” So let’s take a look at a real-world case in point.
Figure 1 displays the weekly chart for spot gold futures with the weekly Elliott Wave count from HUBB ProfitSource.
Figure 1 – Elliott Wave count for Weekly Gold
Figure 2 displays the daily chart for spot gold futures with the daily Elliott Wave count from HUBB ProfitSource
Figure 2 –Elliott Wave count for Daily Gold
Clearly, both the daily and weekly Elliott Wave counts are suggesting a move to higher ground for the price of gold. So does agreement between the weekly and daily Elliott Wave count for a given security or market guarantee that a particular move is sure to happen? Certainly not. But the bottom line is that this could be considered by some to be “an opportunity.” Now maybe you find this compelling and agree that this is an opportunity and maybe you don’t. If not, you are free to go at this point.
For the rest we can move on to…..
Identify a Trade to Take Advantage of the Opportunity
The most straightforward strategy is always to simply buy the security in question. In this case, investors willing to trade futures contract could buy gold futures. An alternative would be to buy shares of the ETF ticker GLD, which tracks the price of gold divided by $100. The one problem here is that with gold at $1,668.30 an ounce, one share of GLD is trading at $166.83 a share. So to purchase 100 shares of GLD would require an investment of $16,683.
You don’t think I’m going to settle for that do you? At the very least a trader could purchase a roughly “equivalent” position for far less money. For example (and by the way this is not a recommendation just an example) an investor could buy the GLD January 2013 call option for $27.20. This is typically referred to as a “stock replacement” strategy because – as you will see in a moment – the position will behave much like a stock position, but at a fraction of the cost.
GLD Price = 166.83
Option Strike Price = 140
Option Price = 27.20
Breakeven price = 140 + 27.20 = 167.20
So GLD has to go up from 166.83 to 167.20 (or $0.37 a share) in order for this trade to breakeven. Above $167.20, the price of the option will move point for point with the shares.
The primary benefits to this position are:
-Even though the position will move point-for-point with GLD shares above a price of $167.20, you only need to put up $2,720 instead of $16,683. In other words, you get roughly the same upside profit potential while committing almost $14,000 less to open the position.
-Likewise, your maximum risk on the option trade is $2,720.
Figure 3 displays the particulars of this position as well as the risk curves.
Figure 3 – January 2013 GLD 140 Call Option ("Stock Replacement" Strategy example)
As I stated at the outset, someone reading the headline of this piece would probably expect me to lay out as forcefully and convincingly as possible, my case for predicting that the price of gold is about to rise. But I am an investor/trader, not a prognosticator.
I spotted an opportunity (the potential for gold to rise based on bullish Elliott Wave counts on both the daily and weekly gold bar charts), and I identified a potential trade designed to take advantage of the opportunity (one that trades exactly like buying shares of GLD but at a fraction of the cost). The one topic I did not cover was how to manage the position, but in reality that is a topic unto itself.
If I were to put this trade on I would decide in advance how much of the money I committed I am willing to risk (in other words, I might consider a stop-loss order of some sort rather than just watching the option price evaporate if things go terribly wrong). I would also plan in advance regarding what criteria I might use to exit the position with a profit if things go the right way.
If the position goes the right way, that’s great, I can make some money. If it goes the wrong way, well, the reality is that that happens sometimes. As long as I don’t risk more than I can afford to lose on a single trade, then hey, no point in pounding the table.
If you can get into the habit of adopting this frame of mind over the long-term, you might be surprised by the good things that can happen.