Sunday, April 18, 2010

THE STRONG HAND THEORY

I’ll start off with an analogy.

Let’s say you just bought a business, a small restaurant. You open for business on Monday and after a week you have grossed $6000. You’re feeling pretty good about how things are going. The business is up and running. Dollar signs are floating in your brain.

Then a week later you get bills for your first food order, payroll & rent. Maybe you also have the misfortune to get hit with the gas and electric bills on top of that. By the time you finish writing checks your +$6000 has turned into -$3000.

Now let me ask you this. Would you immediately throw up your hands, lock the doors and walk away?

I dare say most of us would stick it out a little longer than a week. I would hope that most of us have enough common sense to realize that sometimes we have to persevere to get the reward. And after all, a business we researched so carefully before we started it should surely be given more than a week’s chance to succeed.

However, most gold investors do exactly that, they walk away from their “business” after the first minor setback - even if they logically understand there is no fundamental reason to lock the doors.

This is what traders do when they stop out of gold positions. Let’s face it, the bull isn’t even close to being over yet. By stopping out of a position you are just turning a winning trade into a loser because you didn’t have enough patience to wait for the secular trend to correct a timing mistake.

To put it bluntly, the only way to lose money in a secular bull market is by trading.

Now in my opinion, the difference between a strong investor, one who is not easily knocked out of their position, and a weak one, has nothing to do with how deep ones pockets are. Nor does it have anything to do with how much trading experience one has. And it certainly doesn’t matter what one uses to give themselves an edge, whether it be technical analysis, fundamentals, patterns or chicken gizzards.

I can tell you this: everyone, when they enter a position, starts out as a weak hand.

An investor has to graduate to strong hand status. That, my friends, can only be earned with patience. Let me show you what I mean.

Let’s say you bought mining stocks back in early November 2008. Now it’s April 2010 and your positions are up almost 100%. You are now so far into the green that virtually no correction is going to be able to knock you out of your position. You have basically zero chance of those positions ever losing money for the remainder of the bull market. You’ve become a strong hand.

However, when you entered that position you would have immediately suffered a drawdown as the miners quickly tested the lows in December, and unless you had the conviction to hold on to your trade, you would have gotten knocked out right away for a loss. Look what you would have missed.

It’s very rare that an investor will graduate to strong hand status quickly. The market rarely moves that fast and that far in one direction.

90% of the time the only way you are going to move into the strong hand category is with patience. You are just going to have to let your position work long enough to put a lot of green between you and your entry. Eventually though, you will reach a point where you can weather almost any correction unaffected.

Now here’s the problem with trading. You almost never make it into the strong hand category.

An investor who tries to get “cute” and time short term swings with his investments has the same problem. As soon as you sell you immediately become a weak hand again.

Let me describe what happens to most traders, novice and professional alike.

Let’s say you take a position and you time it pretty well so that the trade goes your way immediately. You’re making money and now you’re feeling pretty good about yourself.

The problem then comes if you don’t have a clear cut exit strategy. If you hold too long the market will almost always pull back enough to take your trade back into the red at some point. When that happens, most traders freak out and sell for a loss, often needlessly.

Or, how about this? You enter a trade but you don’t time it well. You enter at a short term top. The market goes against you immediately; you freak out, sell for a loss, and proceed to curse the trading gods.

Of course if you would only hold tight, the reason you took the trade in the first place will usually turn the trade back in your favor. That is certainly true if you buy in the precious metals sector as the secular bull will eventually correct any timing mistakes. Of course if you panicked and stopped out then you will be long gone when the trend resumes. The market already took your money. “Thanks for playing, come back soon”.

In the last scenario (entering at a short term top) you will probably have two periods where the market takes you back into the red. How many of you can hold through that kind of torture?

Short sellers are in the same position. Selling short, just by its very nature, is going to be pretty tough to achieve strong hand status. Let’s face it, there is no way to get 200-300% in the green like you can on the long side. Plus, bear market rallies are violent affairs that can evaporate a profitable short position in a matter of days if not minutes.

Let me stress again that the only way to lose money in a secular bull market is by trading. As long as you are patient and willing to let investments work, it’s next to impossible to take a loss buying a secular bull market.

Now as long as you aren’t leveraged it just doesn’t make a lot of sense to stop out of a winning position simply because it didn’t do what you wanted it to do in the time you wanted it to do it in.

I suspect a great many gold investors panicked and sold positions during the recent January/February correction. At the same time I suspect every one of those traders realized that the gold bull was far from over!

So why sell? As long as the bull is still intact the only reason to take a loss on precious metal positions would be if you believe an alternative trade would make you money rather than just weathering the drawdown while you wait for the secular trend to resume.

The problem is that for about 90% of retail investors (I’m probably being generous), trading isn’t going to be profitable in the long run. By stopping out you are needlessly turning a winning position into a loss because you didn’t have enough patience to let the position work.

Traders will say that they traded a small loss for the opportunity to make a winning trade. But they also traded a loss for the opportunity to make another loss, thus compounding the problem (which is what happens to most retail traders).

If you had just been patient the bull would have eventually turned your positions green. If you are patient enough those positions will end up being huge winners as the secular bull progresses.

Think about this before you put stops on volatile mining positions. That stop is the only guaranteed way to lose money in a secular bull market. Well, barring an individual company bankruptcy – a problem that can be avoided with ETF’s or ETF like baskets of mining stocks.

What next?

Gold and the dollar are now moving into critical periods. Gold is correcting into a daily cycle low that should bottom in the next week or two.

Whether gold drops below $1085 or not should tell us whether gold is still in an A-wave advance or if the A-wave is coming to an end and a B-wave decline is about to start.


There is also a scenario where gold could still be in a C-wave which would lead to another large leg up, possibly to, or above $1,400-$1,500. The future direction of the dollar will determine if that scenario plays out or not.


If gold is moving into a B-wave decline then we want to take positions as close to the bottom of the correction as possible in preparation for the ride to strong hand status and eventually the next C-wave advance.

If gold holds above $1085 then we need to watch the path of the dollar to determine whether we should exit positions when gold approaches the old highs at $1225 (A-waves rarely make new highs) or if the C-wave is going to continue. In that scenario we most definitely want to hold tight and reach strong hand status for the full ride up into the final C-wave parabolic spike.

I will be watching these various possibilities unfold with great interest and updating subscribers daily on my trading strategies as developments proceed.

7 comments:

  1. "I’ll start off with an analogy.

    Let’s say you just bought a business, a small restaurant.

    [...]

    Would you immediately throw up your hands, lock the doors and walk away?"

    A fatuous analogy. Opening a restaurant takes months of preparation (I know), including contracts (such as leases) that make throwing in the towel far more costly than the results of one week.

    Trading is the opposite. Exits are quick, complete, and usually at low cost (other than price movements). I can buy and sell gold twenty times in a day, and change my mind completely the next day. Businesses such as restaurants don't work like that at all.

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  2. The vast majority of retail traders that try to buy and sell 20 times a day go through all their money in short order.

    Most of us don't want to compete against the big boys. Let's face it the odds are stacked heavily in their favor. They have info we aren't privledged to. They have computer driven trading systems. They are standing down in the pits. They see the order flowas it comes in.

    It's almost impossible to beat them at their own game.

    So why try? It's much easier to just ride a bull market. It's how millionaires and billionaires are made.

    No one is going to get rich trading gold 20 times a day.

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  3. This is torture today. At this rate, it'll be a year before we get the necessary correction! LOL

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  4. Is gold the only market you would recommend buying and holding?

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  5. It is the only secular bull market left.

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  6. Remember: Warren said " When I see a bubble I buy it". He also said "Gold is the ultimate bubble". I agree on both points. For safety sake: Buy, Take delivery and watch in total amazement and glee as the rocket leaves the launch pad. But of course this would require a strong hand to start with. Education makes this possible. Weeeee this investing stuff really is easy.

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  7. Actually I think that was Soros.

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