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Preparing for THE Bottom in Gold: Part 5 – How to Buy

The above background makes one at least somewhat prepared for the upcoming events. However, just as only 5% of new businessâ?? success depends on the idea alone, the general knowledge of the tre...

In the first part of the Preparing for THE Bottom series, we emphasized the need to be sure to stay alert and focused in the precious metals market, even though it may not appear all that interesting. We argued that preparing for the big moves in gold that are likely to be seen later this year should prove extremely worth one’s while. In the second part of the series, we discussed when, approximately, one can expect the key bottom in gold to form (reminder: this winter appears a likely target) and in the third part of the series, we discussed one of the confirmations that could indicate that the final bottom is in or at hand – the gold to silver ratio. The discussion of ratios was extended into the fourth part of the series, where we discussed the ratios between gold and bonds and gold and the gold stocks.

The above background makes one at least somewhat prepared for the upcoming events. However, just as only 5% of new business’ success depends on the idea alone, the general knowledge of the trends and the time are not enough to make one’s portfolio grow over time. One of the remaining 95% success drivers is to act – and to do so prudently. The first action regarding taking advantage of the epic bottom in the precious metals market and the following huge rally is making the purchase / going long in the precious metals market. This is precisely what we’ll focus on in this part of the Preparing for THE Bottom in Gold series. For the scope of this article, let’s assume that one is focused on trading and investment in gold (we’ll write about other parts of the PM market in future essays).

Buying gold sounds extremely easy, especially with a brokerage account – you just log in and click the buy button. Well, just because it’s simple, doesn’t mean it’s easy in its detail. Let’s start the discussion of the details with the general distinction between buying gold as an investment and trading gold. We describe this division and also add the insurance capital. But this is not relevant to today’s discussion as the latter is in the market at almost all times, including today. We discuss its sense and the justification behind it in great detail in our gold portfolio allocation report. However, the long-story short version is that it’s better to have only long-term investments than only trading capital and it’s even better to have both (a core-satellite approach), with the long-term investments being the core part of one’s portfolio and the trading part being the satellite.

Both parts of the capital, investments and trading, are different and thus are managed differently and decisions regarding the purchase at or close to the final price bottom are also different.

In the case of long-term investments, you don’t jump in and out of the market too often as you want to profit on a big price move over time. If you’re correct about the trend, then trying to time every correction could lower your rate of return instead of increasing it. Adjusting the position in the case of big deviations from the main trend is a different matter, though. The point is that thanks to the long-term nature of the investment goal, one can analyze more factors and thus be more confident in outcomes. For instance, analyzing the structural problems of the European Union and investigating demographic patterns around the world can increase the odds of correctly determining the long-term trend in a given market. But it will not help at all with determining the outcome of the next daily trade. Conversely, technical factors that are used in the short run can also be used in case of big trends due to the fractal nature of the markets. In other words, a bigger perspective means more factors that could point to a certain outcome (or invalidate it) and thus a bigger chance of being correct in case of very big trends than in case of the very small ones.

The rest of the differences basically stem from the above-mentioned differences in the probability of being correct. A big probability of being correct means that one can dedicate more capital to the investment position. A lower probability of being correct means that one should dedicate much smaller amounts of capital to the speculative positions.

In fact, using too much of one’s capital for each trade can make one lose money over time regardless of them being correct about market’s movement most of the time (yes, it can be proven and it was). The sad thing is that many beginning gold investors (this link features a simple, yet eye-opening – simulation of one’s portfolio given moderate and huge position sizes), start their investment career with putting their entire capital (or most of it) at stake and purchase heavily leveraged instruments on the most volatile assets. For instance triple leveraged ETFs for mining stocks and junior mining stocks which make their career end rather quickly. Surely, there’s the excitement of sizable gains and sizable declines, but – again, as it was proven by cold calculation – sooner or later their capital starts to diminish instead of growing over time.

In the case of long-term investments, there is a bigger chance of catching a bigger move using a bigger amount of money accompanied by a small amount of particularly favorable entry moments. Such as when gold is moving to extremely low values as it is now (gold is not likely to stay there for long). This makes it particularly important to enter the market close to the final bottom – but not necessarily right at it.

Conversely, in the case of the speculative capital, there’s always the next trade and missing one of the trades or losing 1% of capital on one of them is generally not a big deal. In case of the long-term investment, missing the entry point means either waiting another decade or a few of them (waiting for the entire secular bull and bear markets to create another buying opportunity), or getting into the market at higher (usually much higher) prices. The prices are usually much higher as it’s difficult to assess if the final bottom is already in and staying on the sidelines in case it wasn’t – when this was not the case, one would enter at even higher prices, thus significantly lowering the final profits from the big uptrend.

In the case of short-term trading, the purchase strategy can be quite straightforward – placing a buy order several dollars above the target price (just in case investors start buying ahead of the bottom and the final target price is never reached). And fixing a stop-loss several dollars below the support level that either is the target price (if it is based on a support level that is) or below the highest of the support levels below the target price. Naturally, there are many other trader-specific ways of placing the stop-loss orders or preferred moments of placing the buy order (for instance only after the bottom is reached), but this is something that applies to a given traders’ strategy and approach and is not specific to THE bottom that we are discussing in this essay. In other words, in the case of speculative capital, the major bottom in the precious metals market will not be much different from other buying opportunities. In the case of short-term trades, there’s always the next train and the trade following THE bottom will be similar to other ones.

The real difference will be in the case of the long-term investments. In those cases, it will be particularly important to get into the market relatively close to the bottom, but it’s much more important to get into the market at all than to be very precise regarding the entry point. If gold is to move over $500 higher in the following months, then does it matter if you enter it $20-$50 above the bottom? Not really, but if you entered $200 – $300 above it, it would significantly lower your rate of return. In other words, in light of a big uptrend (either predicted or one that is already in place), the risk originates in staying out of the market, not being in it.

Consequently, perhaps, in case of long-term investments, “is the bottom in,” is not the right question for one to be asking. The better question would be “is the price relatively close to the bottom” and a really good question would be if staying on the sidelines was still a justified form of risk from the reward point of view. For simplicity, let’s use the middle question.

So, since the goal is to make sure that the price is relatively close to the bottom, it is imperative to assess where and when the bottom might be and then plan to make the purchase at around this level. “Around” instead of trying to pick the exact bottom because of the chance of missing it. Besides, who says that one must make the entire purchase at one time?

Indeed, entering the market steadily instead of going all-in at one time seems to be prudent choice in case of long-term investments. Thanks to this approach, one could be too early with a part of the purchase and a bit too late with the final part of the purchase, and one part of the purchase could even be extremely close to the bottom and one of them could be farther from the bottom. However, on average, the purchase would take place close to the bottom, which was the goal in the first place.

What happens if you start buying too early? Well, since you spread the purchase and delay some of it, on average you’ll still get prices that are relatively close to the final bottom – much closer than if you bought using your entire investment capital at once.

What happens if your last purchase is too late? Well, since you spread the purchase and some of it takes place earlier (even before you think it’s the best time to proceed), on average you’ll still get prices that are relatively close to the final bottom – much closer than if you bought using one’s entire investment capital at once.

In both cases, you average out the entry price and increase the odds of buying close to the bottom. As a side note, please understand that the above is not really the dollar cost averaging method even though it is somewhat similar. The latter means making purchases over longer periods of time in general instead of detecting the price at which the market is likely to reverse. What we describe here is a way of taking advantage of such action that would apply to long-term investments. Also, dollar cost averaging might be costly and we generally don’t recommend it.

The psychological benefits of the above approach might be even better. By planning NOT to focus on catching the exact bottom, it’s much easier to really buy close to it. Instead of hundreds of stressful “what if” questions that would follow if the purchase that was not made at the exact bottom and huge risk of missing the bottom by hundreds of dollars (“Come on, I’m not buying now if it will move to my target level shortly. Let’s wait.”), one would have peace of mind and low stress, and the result is greater efficiency in investing. You won’t miss the bottom if you don’t aim to catch it. It’s both: prudent and healthy, so why would you bother with any approach that is not? The only question that you will ask yourself is are we now relatively close to the bottom (either before it, or after its formation). If the answer is yes, then it means that it will be a good time to add to the long-term investment position at that time without the regret of buying at the exact bottom.

The bottom line is that it’s important to spread out the long-term investment purchase over several purchases instead of insisting on catching the exact bottom.

The above might sound too simple to be relevant but it is very relevant because of the amount of capital that will be at stake. A “simple” miss regarding the purchase followed by psychological self-flagellation, giving in and finally purchasing hundreds of dollars above the bottom is not something minor. That’s something with huge implications for one’s portfolio and more importantly for one’s peace of mind. Consequently, it is very important to plan ahead to mitigate the risk associated with the purchase that will likely turn out to be THE purchase of the decade.

Having said that, the question arises as to when to start entering buy orders and when to stop doing so. There can be various approaches, like starting to buy 10% from the predicted bottoming price and then to increase the size of the position every 2%.

However, it seems that there is an approach that should work better than others, as it would not be based on pre-defined numbers, but is one based on the particular situation that the market will be in.

This means making purchases based on the support levels that the market is reaching or signals that are generated (for instance, the ones that we discussed in the previous articles from this series, like the gold to silver ratio moving to the 100 level). This approach seems to be most justified from the analytical point of view because it’s based on the risk to reward ratio.

One starts to purchase early, with only a few signals being seen and then as additional signals and confirmations are seen, the odds that THE bottom is indeed in also increase. Consequently, as the risk to reward ratio improves, the size of the position that is being justified also increases – and thus one can add more capital to the position. The final signals and confirmations come after the bottom (for instance an invalidation of a breakdown below an important support level or a rally on huge volume) – at that time one would not be buying at the bottom, but with the risk that the opening the position should be relatively small (compared to the purchases before the above-mentioned confirmations).

Naturally, the above approach requires staying very up-to-date with the developments in the market, so – as we wrote in the very first part of this series of articles – it’s important to be prepared ahead of time. For those investors, who don’t have time to watch the markets, ratios, cycles, indicators etc. for at least several hours each day when we are close to the bottom, it might be a good idea to get professional assistance, or – especially if bigger amounts of capital are at stake – to have a professional that takes care of that for you.

Summing up, as far as the precious metals market is concerned, the long-term investment capital is very likely to generate largest profits in the coming few years and the way of entering the market will have significant impact on the final profitability of profits from the entire investment. While it could be just another trade in the case of the trading capital, entering the market with the investment capital requires extra care as the position is likely to be much bigger. It seems that – realistically – the best way for most investors to enter the market would not be to try to go all-in at one time, but to spread the purchase around the bottom as there are both psychological and financial benefits of this approach. The moment of initially entering the position and then the moments of adding to it can be determined by watching buy signals from various sources – as more of them become present, the risk to reward ratio becomes more favorable and thus a bigger position becomes justified. Finally, it might be a good idea to decide ahead of time if one will have enough time to carry out the above in a timely manner – if not, then having a professional to do it, might prove very useful.

In this article, we covered the “how” of purchasing from several different perspectives and in the upcoming issue we’ll discuss the “what to buy” question. In the meantime, if you’d like to stay updated on the daily price movement in the precious metals sector while we move to the final bottom (or receive a quick notification if the trend changes), we invite you to subscribe to our Gold & Silver Trading Alerts.

Thank you.

Przemyslaw Radomski, CFA

Founder, Editor-in-chief, Gold & Silver Fund Manager

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