Technical analysis is not a tool used for prediction. It is used to assess the balance of probability in the market. Analysis identifies those outcomes which have the highest probability and those outcomes with reduced probability. Naturally, many people consider only those outcomes with the higher probability — and some slip into the error of deciding that this is a prediction. Do this and it’s a great way to lose money.
The lower probability outcome cannot be ignored. An event with a 70 percent probability has a 30 percent probability of failure and this factor must be included in any trading plan. It is essential to recognize the price activity and levels which indicate that the lower probability outcome is developing. Then the trader must be adept enough to move quickly to reverse positions as required. Trading is about profits, not predictions. This is why chart analysis is used as a foundation for risk and stop-loss calculations because these calculations take into account the potential for failure.
All of which takes us back to gold's and the massive and sudden price fall from $1920 to $1630. This suggests a major change in the trending behavior of gold. This trend dislocation is as severe as the trend dislocation in the Dow , but it came without the same high level of warning. The key question is first, how low can this fall go before it finds support.
Second is to decide if this is a major change in the trend or just a significant correction in the existing uptrend.
We start with support features and this means a focus on congestion areas. These are areas where price has moved sideways and shown a period or reduced price volatility. It’s a do-nothing type of market condition. Sometimes this sideways movement is clearly bounded by support and resistance levels.
With gold the upper resistance area near $1545 is relatively well defined. The lower edge of the consolidation area is better defined near $1480. This gives a narrow trading consolidation band that may offer both support and absorb the down momentum of the gold price.
Traders will look for consolidation patterns to develop in this area. This may include an inverted head and shoulder pattern or a L shaped pattern where price moves between the limits of the consolidation band.
Why not use the area near $1600 as a support area? Price paused briefly in this area in July but the activity did not develop a well defined support or resistance feature. This makes it less probable it will act as a support level in the current market fall.
We expect to see some reduction in the momentum of the fall simply because the fall will be punctuated with bargain hunter buying. However falls of this magnitude usually move all the way to well defined historical support levels before developing rebound or consolidation activity.
There was little warning of this major trend collapse. There is no head and shoulder pattern because the height of the right shoulder is higher than the peak of the head of the pattern. This invalidates any head and shoulder pattern analysis.
Gold is strongly related to the strength or weakness of the U.S. dollar . The surge in the US dollar index in response to increasing fears about Euro stability are the driving forces behind this fall in the gold price. The fall has been exacerbated by the selling activity of ETF bullion funds as their investors scramble for the exit irrespective of any fundamental changes in the demand supply equation for gold. In one sense this suggests the sell-off is overdone, but it would be unwise to make this assumption based on this that the price will rebound and continue the broad uptrend.
The balance of probability has shifted and shifted dramatically. In the game of probabilities the lesser probabilities can never be fully ignored particularly when volatility rules.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.
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