Overbought gold finally fell, presenting bulls with an opportunity to buy the precious metal. Given the speed and depth of gold's fall, it will be a while before the yellow metal makes a new high, probably resulting in a period of consolidation.
In our article dated August 17, titled 'Bullish gold enters overbought territory', we had warned a sell-off was imminent. That's exactly what happened last week. We had also mentioned that gold had moved far away from its mean, increasing the possibility of a sell-off. For the mean, we looked at the 30-week moving average, used by a lot of long-term investors to make investment decisions.
The 30-week moving average acts as a support in a bullish market, and when prices fall back to it, they bounce. At the time of writing the article in August, the 30-week moving average was at $1,512 per troy ounce. We looked at the mini-sized gold contracts (YG) traded on NYSE Liffe. On Monday, the average stood at $1,593 and gold fell all the way down to $1,535 intra-day, only to rally strongly and close around $1,630 at the end of the day. That is huge $100 intra-day swing that would have decimated short-sellers.
There are a lot of reasons given for gold's fall. One is that sellers were taking profits on gold to offset losses in equities. It's one possibility, but we'll never know if it's true. It is impossible to know the reasons why the multitude of investors sold and experts did not survey sellers to get the real reason. The other reason given for the drop is that Chicago Mercantile Exchange increased the margins on gold on Monday. But margins apply to both sellers and buyers, and gold rallied strongly after falling on Monday. This proves the margin reason was not correct. So, the only rational explanation for the fall was the fact that gold was overbought, making a correction inevitable.
So, is it time to buy gold? If you did not buy it at the $1,550 level on Monday, it's a little late. In case you are willing to take the risk of losing a lot, you can buy anywhere above $1,535, which was Monday's low, with a stop below $1,460. But that's a huge risk, with a very high loss if the stop is triggered. We'd ideally wait for prices to come close to the $1,500-level, before buying with a stop at $1,460.
The huge sell-off last week pushed gold to an oversold level on the daily chart. We are measuring the overbought and oversold levels, using the commodity channel index (CCI). When indicator is below the negative 100, the asset class is considered oversold, and above 100, it's considered overbought. On Monday evening, at the time of writing this article, the CCI was at negative 153. Conservative traders buy when the CCI rises from below negative 100 and closes above negative 100.
The speed and depth of gold's fall signals the uptrend may have paused, and we could see a period of consolidation. In consolidating markets, one can buy low and sell high, playing both bull and bear. The safest area to buy is between $1,475 and $1,520, with a stop below $1,460. The area to short would be near $1,800, with a stop above $1,850.
Gold bugs should keep an eye on the stock markets and the dollar. A rally in the dollar or a massive sell-off in equities may push gold prices down. During the crash of 2008, gold fell nearly 33 per cent. However, if there is a flight to safety, then both dollar and gold will rise and the equities will fall. What factors play in the market will only be known once the debt and recession issues play out, and how prices react to support resistance levels on the charts.
The author is based in Chicago and is the editor of www.capturetrends.com
