Friday, November 27, 2009

Planning An Exit Strategy For Gold Investment

The skyrocketing price of gold has some investors nervous about a repeat of past bubbles like the dot com bubble or the housing bubble. Steve Sjuggerud lays out how to plan an exit strategy when your investment is booming. See the following from Daily Wealth.

"We made three thousand dollars just yesterday in gold," a family member told me this week.

"I know your friend Porter says buy. And I haven't heard you tell anyone to sell. But it's starting to feel like the dot-com days... I'm getting worried."

This family member should have reason to be concerned... Yes, he scored big in the dot-com boom – at first. But he later gave back much of the gains.

What did he do wrong? He had no plan. He didn't know when to sell.

So... when do you sell once you're in a dot-com-style bubble?

First off, while it may feel like a bubble to you in gold, I think we're just getting warmed up. The dot-com bubble peaked in March 2003. Remember, at that point, stock trading was the talk of dinner parties. We're not quite there yet.

Also, you don't need to believe Armageddon is near... that deficits and debt will destroy America... to believe gold will go up. Beyond the Chicken Little scenarios, we have plenty of reasons to own gold that have proven to make you money in the past. I've shared a few of those with you in recent issues of DailyWealth:

· You'd have made 17% a year in gold using a modified version of my friend Meb's system.

· You'd have made 15% a year in gold using the "gold versus currencies" strategy.

· You'd have made 18% a year in gold using real interest rates as an indicator.

If you own gold when at least one of these systems says "buy," chances are, you'll do very well. All three of those are in "buy" mode right now.

OK, so when is the exact, optimal moment to sell your gold? The first two systems will get you out in plenty of time before it busts. Another idea is to use a trailing stop.

Yesterday, I asked my friend and math Ph.D. Richard Smith, who founded the excellent TradeStops website, to run the numbers. I wanted him to find the optimal percentage trailing stop for gold.

Of course, I realize all the disclaimers apply: "past performance doesn't mean future results" and so on. But testing trailing stops on gold going back to 1972 should give us an indication of what's "about right."

For his test, Richard set up a simple system: You buy when gold crosses 1% above its 200-day moving average and you sell either when gold crosses 1% back below the 200-day moving average... or when it hits the trailing stop, whichever comes first. By Richard's math, the "optimal" trailing stop for gold is 16%.

My traditional "catch-all" trailing stop has been 25%. That's when I cry uncle... when I say I'm wrong. You can use that wider stop on gold to make sure you don't get kicked out by corrections and can stay in for the full gold move. Or you can use Richard's stop.

One of my own secrets for managing risk and reward is I try to always have my potential reward be at least three times what I'm willing to risk. In simple terms, if our potential upside in gold is 75% from here, then a 25% trailing stop will make sure you're only risking one third as much as your potential reward.

If you always keep the odds in your favor like that, you never end up with a dot-com style bust. You get all the gains on the way up... and only give back a bit on the way down.

Again, the first two of the three systems I mentioned earlier will get you out in plenty of time before a bust. Between those systems and using a trailing stop, you really can't get hurt. You won't be a part of the carnage in a gold bust... You'll take your profits and move to the sidelines.

So don't worry about a bust in gold. Have an exit strategy and stick to it. Then you won't be stuck if gold ends up in a bubble that pops.

This article has been republished from Daily Wealth, a contrarian investment site.

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