No doubt you’ve heard the saying, “if all you have is a hammer, everything looks like a nail.” Psychologist Abraham Maslow coined this phrase to show our psychological tendency to approach different challenges as if they all have the same solutions – a real fallacy.
And if you’ve ever tried to pull a sunken nail from a piece of wood using pliers, you know how difficult it is. Using the appropriate tool, the claw of a hammer, makes the task much easier. The point is, you should match your tool to the specific task at hand regardless of whether you’re a carpenter or investor.
In the trading world, there are really only two types of strategies: trend-following and mean-reversion. Rather obviously, trend-following systems work well in trending markets. Mean-reversion strategies do better when the market is choppy, bouncing higher and lower, but mostly just moving sideways.
Like the hammer and nail, the key is to match your strategy type to the current market environment.
Is the market starting to develop a trend? Then use a trend-following system. This means taking a position in the same direction as the price trend, with the expectation that price will continue trending.
Are we stuck in a sideways range? Then use a mean reversion system. This means taking a position in the opposite direction of recent price movement. You do this with the expectation that the price will reverse or “revert to the average.”
Gold right now is clearly in a very choppy consolidation range, making it an ideal environment for a mean-reversion strategy. But before I share the exact rules of one simple (and highly profitable) strategy you could use in this situation, I’ll explain how I knew gold trend was over last year.
Here’s a chart of gold futures prices going back to 2006:
In Exhibit A, highlighted in green, notice how gold shot exponentially higher and then, just as quickly, collapsed. Usually this pattern suggests the current gold trend will stall. I looked back and noticed the same pattern developed in gold in early 2006 (Exhibit B, also in green). Following that pattern in 2006, the gold market went sideways for about 15 months, chopping above and below $750.
Exhibit C shows a common indicator that measures the strength of a trend. When it peaks, and starts to decline, you can expect a period of sideways action and should think about using mean-reversion strategies. In 2006, gold trend entered the sideways period when this indicator peaked at a value of 55.
Now, fast-forward to late 2011. Again, it was the pattern highlighted in green that warned me of gold’s consolidation period to come. To add confirmation, the gold trend strength indicator was topping out at the same value, 55, that I saw in 2006.
The message is clear: gold will be choppy and I’d look at mean-reversion strategies in this situation.
The simplest of mean-reversion strategies is to establish an average price, then be a buyer when the current price is below the average. Likewise, you’re a seller when current prices are above the average.
Establishing the average price is easy. The upper range of gold’s move was around $1,900. The lower range was $1,500. That puts the average of the range neatly at $1,700.
With that established, my rules were simple:
1) Buy 1 gold contract each week that closes under $1,700, and
2) Sell Short 1 gold contract each week that closes above $1,700, and
3) Stop trading if/when gold breaks outside the range (i.e. above $1,900 or below $1,500).
By definition of the rules I established, we won’t have a losing trade until gold breaks above $1,900 or below $1,500, which it hasn’t for the past 13 months.
So far, this strategy has generated 49 winners out of 49 trades and netted $515,820 in profits.
Of course, this strategy will get turned off and put back into the toolbox once gold starts trending again. But for now, gold is a nail… so we use a hammer.
If you haven’t done so already read the Survive & Prosper issue on “We Hope You Were Not Married to Your Gold Investments.”