Why it’s Time to Back up the Truck and Buy Silver

By on August 26, 2011

Both silver and gold have been whacked over the past few days, with gold falling nearly $200 an ounce and silver falling nearly $5 an ounce.

It’s all over the news…

The great precious metals bubble has popped.

People and governments are no longer fleeing into precious metals.

Confidence is returning and therefore these “safe haven” assets are being shed faster than a turtleneck sweater in the Texas summer heat…

What exactly does this mean?

It means it’s time to buy silver.  Let’s take a look at why.

True, traders who chased these markets higher got burned, got left holding the bag, and are shaking their heads in exasperation wondering what went wrong.

“I thought the world was in trouble,” they mumble, as they hide their trading statements from their spouse.  “Gold and silver should be moving higher.”

Trying to contain their frustration and rage, they pour themselves a stiff drink and contemplate the absurdity of the universe.

Is the global economy in trouble?  Yes.  Therefore, gold and silver should be moving straight up . . . right?

Wrong.  Absolutely wrong.

In fact, nothing could be further from the truth.

There is no market on the planet that goes straight up or straight down indefinitely.  Even the strongest market under the protection of the strongest fundamental evidence needs to pause and take a breath.

Profits get taken.

Weak hands with tight stops get shaken out.

It’s just the way markets cycle in and out and, quite simply, it’s the way markets work.  In trader-speak, we call this, “Reverting to the Mean,” which also means “heading back to its average price point.”

It’s critical to understand this.

In fact, I’m going to say this as clearly as I can: Every major market will always revert back to its average price.

If you succumb to internal psychological pressure and chase a market that is going higher, you need to know in advance that you will be taking some heat when it goes against you.

Because it will go against you.

This is absolutely okay as long as you understand this and you can plan your risk accordingly.

Can’t stand the market going higher without you any longer?

Fine.  Just buy a small position.

You had planned to buy 1,000 shares?

Great.  Buy 100 instead.

This will quench your desire and allow you to sleep at night.  You can always buy more on pullbacks.

It’s the poor guys who buy the dead highs of a move, betting their whole ball of wax on a move that is well extended beyond the mean, who get shaken out and have to pour the stiff drink and hide their statements from their spouse.  They have no wiggle room.  They have to be right.  Dead right.

They wonder why every time they buy, they eventually get stopped out – right about the time the market reverses and continues going higher.

Has this ever happened to you?

If so, you bought a market that was extended well beyond its “average price.”

Psychologically, extended markets suck in a lot of “fresh meat.”  People watch the rising price day after day and agonize over all of the profits they are missing.  “There it goes again,” they say, “without me!”

These are the same people that actually create short term market tops.  Remember, a chart is merely an emotional graph of the market participants.  Greed, elation, fear and panic –it’s all there right on the chart.

The best example of a “Reversion to the Mean” level is the 21 period Exponential Moving Average (EMA) on a daily chart.

This level represents the average approximate price a particular market has traded at over the past 21 days.  A market that is trading well above or below this range will pause and start to work its way back to this level.  In other words, for those of us who are in the know, this represents the absolute best entry opportunities.

How to play it?

First off, I like silver here better than gold.

Gold has broken out to new all-time highs while silver has been holding back.  Silver will eventually catch up with gold and break out to new all-time highs.  This means that, for now, percentage wise, there is more upside room in the silver market when compared to the gold market.

The key with timing these trades “back to the mean” is to know, once you’ve picked up the position, when to get out.

True, you can just buy and hold but there is a more important question to ask here: What if you could time the ebbs and flows of the silver market?  Getting in on weakness, out on strength?  Not holding through the down moves?

To do this, do the following:

  1. Be patient.  Wait for that move back to the 21 period exponential moving average (EMA).
  2. Once you’ve entered a position, set a target 10% above your entry.  (For example, if you entered in at $40.00, then you would set a target to get out at $44.00).
  3. Place a protective stop 15% below your entry.  Why 15%?  Because 10% represents a “normal move” off the mean.  By placing a stop loss outside of this normal range, you will be able to withstand the normal ebbs and flows of the silver market and not get stopped out unless a major reversal in price is underway.
  4. Once your target is hit, sit back and wait for the next “reversion to the mean.”  Remember, that EMA price can change.  In an up-trending market, that “mean” price will continue to rise.   The first time you get in at the mean, the price may be $40.00.  On the next pullback, that “mean” price will be rising and your next entry might be $40.90.  The actual price doesn’t matter.  It’s that level, that average price point, that’s important.

So, silver sold off $5 an ounce and gold nearly $200 an ounce over the past few days?

Great.

Open up the daily chart and take a look.  These moves weren’t the disasters a lot of financial pundits made them out to be.

Yes it was a disaster for those who chased and bought the dead highs on gold or silver using leverage.

But for those of us in the know, those of us who were being patient, it’s these “disaster” moves right back to the “average price” (in this case the 21 period exponential moving average on a daily chart) that represent the best trading opportunities.

In life, we strive not to be average.  In trading, average is the place to be.

 

About John Carter

John Carter's father was a Morgan Stanley stock broker. One day during high school, John came home from the mall where he was working at a store making cookies. He had saved up $1000 over the course of... Read Full Bio »

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