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May 5, 2011

Slaughterhouse Cinco

Today's action reminded me of one of my favorite stories from Market Wizards in which a young Paul Tudor Jones decides to be macho and bids for 100 cotton contracts on the exchange floor. When he immediately gets filled, he turns pale, knowing that he'd been trapped and was about to have to take a several-cent hit on 5 million pounds of cotton... quite a significant sum in the late 1970s. Another pit trader standing at his side leans over and advises him, "If you need to use the bathroom, do it right here."

A lot of trouser-wetting was no doubt induced by today's precious metals action, but before we get into the details of the slaughter and what it tells us, I'd like to indulge in a bit of introspection. Twice this week, I altered my view about an issue and was wrong to do so each time. First, consider what I wrote in the weekend letter:

Trying to squeeze every dollar out of a move is counterproductive, not only for its futility, but because one must have time to gather thoughts for the next trade. My focus, therefore, has shifted toward exiting positions in order to be prepared for the next big play.

Then Monday, I decided that since gold seemed ready to put in a daily cycle decline after all, perhaps it would offer an opportunity to position for a final parabolic run. The trading plan seemed well-formed except for one flaw which I mentioned in yesterday's comments: the chance that gold suffered a much deeper daily cycle correction.

Second, consider how many times I warned that the biggest threat to the long PM trade was the dismal sentiment readings under the dollar. Then only yesterday I wrote that the outward panic surrounding the dollar did not jive with those readings, so until proven otherwise, I was assuming more damage would be done. Good timing for a flip-flop, eh?

I am usually keen to trust my trader's instinct, which typically serves me well, especially when it meshes with the cycle outlook. As for the current situation, I have mentioned repeatedly that based on cycle and sentiment characteristics, I saw this latest trade as a lower-probability play than what was presented at the January and March lows. The takeaway here is something I've learned before but about which I occasionally need reminding: it is okay to miss a trade.

We are basically playing a probabilitic game and trying to take trades when the odds favor us. Our cycle and sentiment tools provide the bulk of that analysis, but once a trader's instinct has been honed, gut feel can play a small part in judging the odds. In the recent case, both instinct and cycle states were suggesting lower probabilities of success, and I should have applied the wisdom in the weekend letter.

For now, I am still holding my remaining precious metals positions. Professional traders make money buying panics, not selling them. Nevertheless, I did not buy into today's drubbing because I have all the risk I want on my books for now. My dollar short and euro calls were jettisoned, however, as soon as I saw the dollar react positively to the jobless claims number.

DX Daily

As previously noted, intermediate dollar cycles have a tendency to terminate with a short daily cycle, so despite yesterday being only Day 13, we cannot assume the DX will turn lower again. In fact, given the strength of today's rally, I am going to operate under the assumption the 3-year low has been printed until proven otherwise. If there is to be any chance of seeing the 3-year low pushed further out, today's moves in gold and the dollar will need to be reversed very quickly.

DX Weekly

The formation of a 3-year low for the dollar would eliminate any further prospects for a final gold run, but does not mean precious metals will go straight down nor that gold could not even take another stab at its high.

Gold Weekly

Of course, last year's cycle did not coincide with a 3-year dollar low, but gold is currently seeking a daily cycle low. Furthermore, the severity of the selling suggests a violent snap-back rally is due once the cycle low is printed.

My trading plan is as follows. Once gold bounces out of a daily cycle low, I will decide whether or not to sell the bounce based on market conditions, specifically the behavior of the dollar. If the dollar holds its gains, and especially if the DX has formed a weekly swing low, I will dump my remaining PM positions. If the DX has forfeited today's gains, and especially if it is already setting new lows, I will ride things out until a 3-year cycle low can be identified. If the latter scenario occurs, I will stick with yesterday's plan of shorting some gold contracts against my options in order to gain a free position.

Equities were weathering the dollar strength most of the day and were offering one of the only bits of behavior in support of classifying the dollar bounce as a monster head fake. Alas, the stock market broke mid-afternoon and lost the SPX 1340 pivot.

SPX Daily

The 65DMA, along with the cycle trend line, may offer some support under this decline, but since the daily cycle has already entered its timing band for a low, I suspect those levels won't hold for very long. Stocks should decline into a daily cycle low within the next two weeks, and the level at which that low prints will be key to our effort to build a short book.

Docfolio Update: Sold (to close) euro calls; Covered DX short


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