Sunday, July 27, 2008

Trading Gold Corp's Relative Strength

In the previous post, I mentioned the importance of managing risk by hedging. I also talked about how profitable traders tend to buy strength and short sell weakness. One way of following both principles is to buy a company that is showing strong relative strength, and short sell the index.

The following chart shows Gold Corp, symbol, divided by an ETF that tracks the entire gold stocks sector,

The above chart shows how your profit and loss diagram would look like if you had bought shares of Gold Corp and short sold an equal dollar amount of XGD. With this type of strategy, you are not betting if the price of gold will rise or fall, since you could make money either way, so long as Gold Corp continues to outperform the index.

This type of strategy does not involve making forecasts or trying to predict what the future has in store. It only involves following the trend for as long as it lasts, and getting out when the trend ends.

The next charts show XGD by itself. As you can see, it is very choppy, trendless, and difficult to trade at this time:

One difficulty that trend traders sometimes face is that they need to wait for long periods of time before a major trend develops. But by using ratios, hundreds of combinations can be created, and trends can be found.

By trend trading hedges, I feel that I significantly reduce the level of risk, and at the same time, extract money from the hedge by following the trend. Reducing risk is important, especially if you are dealing with Horizon ETFs, since these products are exceptionally volatile.

The chart below shows an ETF a have talked about a few times before, This ETF tracks the price of natural gas, and, as you can see, is one of the riskiest funds out there:

If you had made a $10,000 investment in this fund three weeks ago, it would have dipped to nearly $4,000 in a matter of days. This is why it is essential the manage risk, and cut losses short if the trend moves against you.

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