Are You Ready for Gold's Volatility?

11/18/2010 1:00 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Gold is a market I started following in a serious manner not too long after the 1980 top. For quite a few years after gold peaked I was at many financial conferences that were attended by "gold bugs". Since I have always viewed any market from a technical standpoint those that held their gold for many years, hoping for a repeat of 1980, did not like my view as no clear trend developed for 20 years. Only in my wildest dreams did I ever expect the interest in gold to reach the levels we are currently seeing. Since the monthly and weekly outlook for gold are both still clearly positive as they have been for several years  I wanted to try and prepare those new to the gold market for what they can expect in terms of volatility.  In Monday's daily chart I noted that the volatile action the prior week suggested that gold might be ready for a deeper correction. Gold has had a rough week so far as with Tuesday's closing price it is already down over $85 dollars from is most recent high.

Figure 1


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Since 2001 I have identified five major rally phases in the gold futures that have taken prices from $255.80 in March of 2001 to the recent highs at $1424. Many of these rallies lasted over a year as from the March 2001 lows gold rallied until February of 2003 as gold reached $390.80. This was a gain of 52.8% (as noted in blue on the chart) and this high was followed by an 18.1% decline from the highs (noted in red) that lasted just nine weeks. The decline was sharp enough to slightly break the 15 month uptrend, line a. For the next six months gold traced out a triangle formation, lines b and c. This is a corrective or continuation pattern that I have often seen in gold. The triangle formation was resolved at the end of August 2003 and by the following April gold had reached $433. This was a 36% rally from the lows at $319.80 and in the next eight weeks, gold dropped 14.3% from its highs.

Figure 2


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Though I will be focusing on the rallies that took many months not just weeks, those shorter corrections should not be ignored as they have often done a good job of taking weak long positions out of the market. The first weekly chart starts in 2001 and up through August of 2002 you will notice there are three corrections that look brief in terms of the major trend but nonetheless gold declined 6- 10% from its highs. Given the scaling of the weekly chart they do not look like much but for those who were long it was likely much different. They are much more evident on the daily chart as the 6.8% drop from the March 9, 2001 high (point 1) to the March 30th lows (point 2) lasted only three weeks. Even more dramatic was the seven day, 11.5% plunge in May 2001 from the high at point 3 to the lows at point 4. Then in early September gold rallied over 10% in two days peaking at point 5 where prices then reversed. Towards the end of November gold bottomed out (point 6), it had declined 9.4% from the highs. When we look at the correction in late 2009 and early 2010 this discussion will become even more relevant.

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Figure 3


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This second weekly chart begins with the June 2004 lows at 371, illustrating the 23.6% rally to the December 2004 highs at $458.70. This 23.6% rally was followed by a $47 decline (11.4%) and the formation of a triangle, lines a and b. Gold completed the triangle in mid-August and then began a steady climb that terminated in May 2006 with gold peaking at $732. This 77.8% gain caught the world's attention as the press began to talk about the January 1980 highs of $873. Of course the rapid five week plunge to $546.50 (25.35%) dampened the high bullish sentiment as gold again traced out a triangle formation, lines c and d.

Figure 4


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Gold remained its broad trading range for the next 16 months and it was finally able to breakout to the upside in September 2007 (see arrow) as there were mounting concerns over the financial system. Over the next six months gold moved sharply higher as global investors started to treat gold as a proxy currency more than an inflation hedge. From the lows at $546.50 to the highs at $1033, gold had gained 89.2% as the 1980 highs were decisively overcome. The gold bulls at the time pointed that if you compare the dollar in 1980 to its current value gold should be closer to $2000. The correction from $1033 was quite severe as gold dropped below the peak at $732, eventually bottoming out in October 2008 at $681.40. The flag formation (lines a and b) amounted to a 34.1% decline from the highs and gold did hold its uptrend from the 2006 lows, line d. The decline was likely accentuated by the massive global dumping of all asset classes in the fall of 2008.

Figure 5


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This final weekly chart is updated through the weekly close on November 12, 2010. The flag formation from 2008 (lines c and d) was completed in early 2009 as gold rallied slightly above $1000 before retreating by 14.8%. Though I have not highlighted it gold once again traced out a triangle formation that was resolved by a rally to $1227 in December 2009. Bullish sentiment was very high at the time as many were now looking for gold to reach $1500. The triangle formation that developed reflected a 14.9% decline from gold's highs but more importantly it reversed the sentiment on gold. The correction lasted from the start of December 2009 until early April 2010 and lasted long enough to turn many analysts, as well as investors, bearish on gold. In March some were even advising short positions in gold but by mid-April the triangle was resolved and the ensuing rally has been relentless. During the 24 months from the October 2008 low of $681.40 to the 2010 high of $1424.30, gold gained 109%.
Of the corrections covered in this article, the average decline was 23% and if you use the recent high at $1424 that would imply a $327 drop or a decline in gold to $1097. Do I think that is likely? Let's look at the current daily chart for a better perspective.

Figure 6


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This daily chart of the current December 2010 Gold contract encompasses the February lows at $1048 (point 1) through the close on November 16th. One day after the February lows I noted that gold may have bottomed as good Fibonacci support had been reached.  The rally into the June highs turned the sentiment to a bit more bullish but that was reversed as the decline from point 2 to point 3 was sharp enough to stop out many longs even though it held the 50% retracement support of the rally from February to June. The rally from the summer lows has clearly caused a flood of new investors into the gold market and the Fed's QE2 has also helped. Even though gold is now down over 5% down from its highs there are no clear signs that it has topped out. The monthly on-balance volume (OBV) did confirm the October highs and it should make further new highs this month. The weekly OBV made a new high two weeks ago, corresponding to the new weekly closing high and even the daily OBV peaked with prices last week.

That said, I would like to discuss a few potential scenarios

  1. The current decline is just a minor correction that could hold the minor 38.2% retracement support (in red) at $1320 and then gold should resume its uptrend in the next week or so. If gold is able make new highs or challenge them by the end of the month it could set the stage for a more prolonged correction such as the one we saw in 2009-2010.
  2. Gold may stabilize for a few days or bounce slightly before dropping to the $1280-1300 area where the minor 50% and major 38.2% (in black) support levels converge. Then gold is likely to bounce back to the $1320-50 area and may stay in a range for a number of weeks before the intermediate term uptrend resumes.
  3. The third, and least likely scenario for now given the positive technical outlook is for a more serious decline that would take gold below the $1250 area and possibly even to $1200. In my view it would take that much of a decline to discourage some of the recent buyers and it still would represent only a 15% decline from the highs.

So I do not think a 23% decline to the $1097 is likely at this time as a drop to $1150-1200 is likely to be enough to scare most investors out of their long gold positions. It is interesting to note that for 2011, the yearly uptrend is at $963. Of course I will be updating my analysis of the gold market each week in the daily chart section and by the end of November I should have a clearer idea of where gold is heading. If you have never invested or traded gold I hope this historical review will help prepare you for its volatile price action.

Tom Aspray, professional trader and analyst, serves as video content editor for MoneyShow.com. The views expressed here are his own.

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