Smart Wallet

It appears that 2012 is off to a great start; however it is important to remember that volatility continues to rule the marketplace, which means there will be great trading opportunities in the coming months for those who are ready to capitalize.

That being said, our topic today is about one trading pattern that traders need to avoid. In my last blog I talked about gold prices and got me thinking one trap that traders need to avoid, which is the parabolic price rise.

At first glance it sounds like a great move most traders want to want to capture. Because prices are moving dramatically, traders can become very excited to try to get into a position; however unless you had a position before the rally, there is a greater chance of buying at the top and selling at the bottom then there is to make profits midway through.

Gold is a great example of a parabolic rise because there was so much hype surrounding it. Everyone was talking about gold and wanted to own the precious metal to protect their capital. As we pointed out in last week’s column gold has been on the rise since 2009; however, the biggest rise happened in early June.

The fact that central banks have been steadily buying gold since 2010 has helped to push prices higher in the last few years.  The sharpest rise occurred in early-July when prices skyrocketed from around $1,500 to $1,923.70 in two months.

The reason the parabolic rise is so dangerous is because you don’t really know how high the price can go. Although the break above $1,700 was accompanied with strong volume, there was not a lot of follow-through in the following session. For astute market players, it was a little obvious that gold didn’t have enough momentum to break resistance at $2,000.

At $1,700 the price was over-bought and it was only a matter of time before we saw some profit taking. Not only do you not know how high the price will go but at the same time the unwind of the trade is extremely rapid.

Investors who have been in the trade long-term take their profits, which drives the price down. Other investors who came a little bit late to the party see the selling pressure and then jump on the wagon to protect their profits and the third wave is from the investors who bought at the top and are now desperate to get out because their stop-losses have been triggered.

Although gold is a great example it is not the only one. The second example I want to show is of Citigroup (C) in 2010. Looking at the chart we can see that in February the price hit a low of $31.10 and a month and-a-half later rallied to a high of 42.20. This presented a rise of more than 35%, which is why it was not surprising to see some profit taking.

Price managed to recover and by mid-April, the price hit a high of 50.70, which is a gain of more than 61%. The two selling days on high volume was a strong signal that the rally was very much over as prices tested support at $44.

The Citigroup trade was a little bit more difficult because of the two separate rises; however, the first selloff, was a good opportunity to get into the trade. The volume in March was relatively low, compared to the April sell-off, so there was a good indication that prices wanted to move higher.

Instead of trying to play the parabolic rise, a better trade might be to take the contrarian view. We will talk about this in next week’s blog. However just to give you a preview, this is taking the opposite view of what the herd is doing. It can be extremely dangerous if not played right but can be extremely profitable when it works.

Before we end this we want to point out that it appears that gold prices are back on the rise. On Jan. 11, prices managed to break above the 200-day moving average, which is what we were waiting for. Although prices appear to be moving higher, we would like to see volume a little bit stronger as the 50-day moving average around $1,670 acts as the next resistance level.