The Case for Buying Gold Stocks

05/17/2011 6:00 am EST

Focus: STOCKS

Extreme oversold conditions in gold stocks mean that a big correction could unfold, but traders who are prepared may be able to play the volatility to generate quick profits.

Gold stocks are in a correction that could turn out to be the largest and deepest since the crash of 2008.

However, now is not the time to panic, but instead to evaluate where gold stocks may go and where buying will come in to support the market.

We utilize moving averages, Fibonacci retirements, Bollinger bands, and price action to get a good idea of where the market may bottom. Additionally, we always consult sentiment polls, fund flows, and options activity.

Starting with the large caps, as tracked by the Market Vectors Gold Miners ETF (GDX), here is what we see.

The lower 200-day Bollinger band marked bottoms in 2004, 2005, 2006, and 2007. It is currently at $49.99 and rising. The 400-day MA (currently at $52.26) marked key support points in 2003, 2006, 2008, and 2010.

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The bullish percent index is at 43%, which is oversold, but not extremely oversold. There is a confluence of support in the low $50’s. The 38% retracement from the 2008 low is at $46. That is our realistic worst-case scenario.

Meanwhile, the Market Vectors Junior Gold Miners ETF (GDXJ), which tracks the larger juniors, closed recently at $34.69. Our chart below shows a confluence of support at $31-$32. The 200-day lower Bollinger band is at $26, but it will reach $30 before the end of June.

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To sum it up, gold stocks are oversold and nearing that extreme oversold condition. This is a volatile sector. Use the volatility to your advantage.

During corrections like these, you must wait for a very oversold condition, rather than just a plain oversold condition. Not only do you protect yourself, but you give yourself a chance to profit quickly, as gold stocks tend to rebound very quickly when reaching the extreme oversold state.

By Jordan Roy-Byrne of The Daily Gold

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