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Bounce or Reverse? Gold Might Do Neither

Professional traders are almost never cheerleaders. When a trader starts with a bias for the market to go one way or the other, then every one of the market's jiggles and retraces along the way serves to shake that trader's confidence. The trader might very well be right about direction, but more often than not, the scary zig-zag action has spooked him or her into closing the position early or even reversing course. When markets are volatile, it can be a relief to turn to the quiet objectivity of technical charts.

In April, amid a storm of conflicting predictions of gold getting ready to fall through the floor and gold about to rally because of central bank buying, we suggested simply that gold needed a lower low before it could attempt a serious bounce . That analysis was based on what the charts were telling us, not on sentiment, and not on efforts to forecast unpredictable news events. As it turns out, gold is making lower lows, and now it is time to assess whether a bounce or a major reversal can occur.

In our view, the gold chart really would look better with still lower lows before we see a rally. We explain that case below. However, it is also possible that the downward correction is over and that gold could take off in a rally from the last low. How should a trader deal with that uncertainty?

Long-term position traders probably could start scaling into a position in the current area while being prepared to see some choppiness or lower lows before the expected rally arrives. A year from now, they probably wouldn't regret their decision.

Medium-term or swing traders would want to see some confirmation that the downward move is over before they start looking for long entries. We discuss what that confirmation might look like as we describe our primary scenario below, because confirmation of a rally from here would mean that our primary scenario wasn't working. (Remember, a good trader always has at least two possibilities in mind, and usually more.)

In our main scenario, gold has almost completed its big correction from the 2011 high, and it just needs to trace out the final small part of that correction. On the monthly chart, you can see the big (a) (b) (c) corrective pattern that comprises what we think is large wave (4).

The strong downward wave (c) is one of the reasons so many gold commentators have issued bear calls in recent months. In Elliott Wave analysis, c-waves are often powerful, impulsive moves. Typically, many traders mistake a c-wave for a third wave, and they end up trapped after the reversal has already occurred.

Gold has been behaving fairly nicely with the channel support on the monthly chart. One sign that gold needs a lower low would be a monthly close below the support line, which is currently around 1,229.

Now consider, if gold decides to go lower from here, what would be a sign that it doesn't want to stop? In other words, what would tell you that the idea of a big corrective wave (4) is wrong, and that there's danger of getting stuck long in a bear move? If gold breaches the 2008 high of 1,102.20, which we have labeled as large wave (1), then price can't be in a fourth wave. In that case, we'll start paying more attention to the gold bears and consider looking for short entries either on a breakdown or a retrace. However, for now we are treating this as a fourth wave that isn't finished yet.

The weekly chart shows gold as having moved through a small downward wave iii and part or all of an upward wave iv. Next, it should complete wave v -- a process that could be quick but is more likely to drag on for several months.

Again, with the expectation of somewhat lower lows, what would tell you that you're getting caught facing the wrong way? In the count on the weekly chart, if price reaches above the small low of 1,336.3 in May 2013, which is labeled as i, then the precise count on the chart can't be correct. That itself would not be confirmation of a rally, but it would certainly be a warning sign. If price crosses above the 78.6% retrace level at 1,415, that would be stronger confirmation that we were seeing something more than an upward retrace.

In previous articles, we have described our expectations for the rally in stocks to end in coming months and the US dollar to continue climbing upward in an impulsive move. A deflating (rising) dollar would normally be bearish for gold, while a sharp decline in stocks and bonds would have the opposite effect. One way that gold might respond to those competing influences is to embark on a time-consuming, somewhat sideways pattern. This could take the form of an ending diagonal wave v downward, which is what we are expecting. However, it also could take the form of a leading diagonal upward from here, which would mean the bounce had already begun, albeit with hesitation.

There's one final thing to note about the big picture. A rally from here or slightly lower would not necessarily mean price was going up in large wave (5). That is one possibility, but another path to consider is a large correction other than a wave (4) might be taking place and could have several more years to go . For example, it could be forming a big (w) (x) (y) pattern, of which the current low area was just the (w). For most of us -- traders and investors alike -- there is profit to be made regardless of the type of bounce we see. However, a more lengthy correction would consist of smaller, choppier moves than an impulsive wave upward. One's trading style would have to be adjusted accordingly.

The bottom line for swing traders is that it can be risky here to jump on something that looks like rally, unless there are other confirming signs such as a nicely completed pattern or a breach of important levels overhead. If price starts tracing out some kind of diagonal pattern, then one needs to trade a smaller timeframe, and that can be difficult for a trader to manage based on weekly or daily updates. Swing traders might consider looking to the many other possible markets to find better trades.

This article originally appeared on Trading on the Mark .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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