Stocks & Commodities V. 4:8 (299-300): Letter to Jake by Stuart J.

Pahn

Letter to Jake
by Stuart J. Pahn

Ed. Note: This is a copy of a letter between two traders. Stocks & Commodities has included it as an
example of some of the "real world" considerations that go into making a trade.
Dear Jake,
You asked me to explain some of the main factors I consider when making a trade. Let me use my most
recent trade as an example.
As the attached equity run shows, I sold short a contract of June Comex gold on May 1, at $345.10, and
covered it May 6 at $343 for a gross profit of $2.10, per contract.
The accompanying chart shows the daily price action of June gold with a couple of moving averages
superimposed and volume plotted below the price bars. As a long-time Wyckoff student, I usually begin
analysis by examining the price/volume relationship.
To set the stage for the above trade, notice that toward the end of March gold had a high-volume break
with price giving ground very easily. In early April, the market bottomed out and began a gradual and
somewhat labored recovery. The five-day moving average of volume highlights the expansion of volume
on the break and the relative contraction of volume as the market came back up. This was potentially
bearish action in that it showed supply, in terms of the flow of orders into the marketplace, to be greater
(and of superior quality) than demand, at least near-term. The market was moving down with ease on
expanding ding volume and up with difficulty on contracting volume.
Elliott Wave theory adds another dimension to the setting. The last March high-volume decline unfolded
in a five wave pattern. I have labeled the wave "count" on the chart. The April recovery (on receding
volume) unfolded in three waves labeled A-B-C, and retraced to the $351 level, precisely 62 percent of
the preceding break. This was a bearish wave pattern and Fibonacci relationship. Also, it is interesting to
note that the halfway point of the December-to-January advance is exactly the same price, $351, giving
that level double significance as a potential resistance zone. Thus, at point Co, the market became a
full-fledged candidate for a short sale from both Wyckoff and Elliott Wave perspectives.
Let me digress a moment to say a few words about cycles. There is a very regular nominal 12-week cycle
in gold which I can document back to January 1985. Using spectral analysis techniques, I have identified
six repetitions of this cycle which account for four fairly important lows, including the July 1985 low (not
shown), the September 1985 low, the December 1985 low, and the March 1986 low. The projected
window for the next low of this cycle is the last two weeks of May. As the April rally began to crest, this
was the third factor in the backdrop of my thinking.
Notice that point C was the first of three peaks, each one lower than the next. This was distinctly bearish
behavior revealing the market's inability to make further upside progress. When I examined this chart on
April 30 and saw the extremely narrow price range of that day, I was convinced the moment had arrived
to take a position for a probable decline into the late May cycle low.
The narrow price range on April 30 was significant for the following reason. Narrow price range and
relatively high volume (i.e., relative to the recent past) at the top of a rally can mean only one thing: that

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Stocks & Commodities V. 4:8 (299-300): Letter to Jake by Stuart J. Pahn

supply is present. Notice that the volume on April 30 was the second highest of the previous seven days.
On the previous day, the volume was only slightly higher and, relatively speaking, the market had moved
up easily.
What I am trying to get at is this: thinking in terms of effort vs. reward (effort being represented by
volume and reward by the consequent ease of price movement) on April 29, the market got a fairly good
upside reward for the effort expended. But on April 30, given virtually the same effort, there was no
reward. The rally had been blunted. Sell orders had overwhelmed buy orders, as indicated by the market's
failure to make further upside progress. The same volume which had caused price to move up with
relative ease the day before, could not move the market at all on April 30.
I went short the next morning A variety of studies which I keep on a daily basis had already begun to roll
over. I will not discuss these as this is getting a bit wordy, but I did want to mention that momentum
studies are a part of my tool kit.
I was encouraged by the weakness on May 1 as the market had declined easily on only slightly higher
volume than had blunted the upmove the previous day. Supply appeared to be the dominant force. I was
comfortable as the market hesitated and moved sideways, unable to mount a rally during the next two
sessions. I felt certain a more significant break would follow.
Alas, however, the best laid plans of bulls and bears go astray.
The date I covered, May 6, the opening call was $1.50 lower. To my delight the actual opening was $3.20
lower, and in the first two minutes, the market traded down $4.70. I felt sure I had it made. Toward the
end of the first five minutes of trading, as the market began to struggle back to the upside, I did, however,
make a mental note that the low had been almost exactly a 62 percent retracement of the rally from point
5 to point C.
I was getting a bit concerned as the market gradually recouped about half of its loss for the day in the first
two hours. But I "hung in," feeling sure that, at the very least, a retest of the low was called for.
When the market continued its recovery in the third and fourth hours of trading, I could see my scenario
beginning to crumble. Meanwhile, platinum was putting in a stronger than expected show, and silver, the
weak sister of the precious metals group, was actually up on the day. I was befuzzled.
I have two cardinal money management rules which have served me well over the years. As you know,
money management is a discipline every bit as important in trading a market as the underlying analysis,
and possibly more important. Rule number one is: never, ever if you can possibly avoid it, let a profit go
into a loss. Rule number two: if you are corn-fused (as they say in Iowa), get out. I employed both rules
simultaneously and used a dip during the last hour to humbly accept a small profit. Perhaps the next time
I will be shrewder and buy shorts on the low of the day.
Nevertheless, although the analysis broke down, the strategy was correct. The next day the market
continued to rally and closed well above the $345 price at which my shorts were initiated.
Jake, I could go on and on here. I could discuss the weekly and monthly charts which are also part of my
battery of tools. I could go into the gold/silver and gold/oil ratios and the fact that silver is now below the
cost of production and how these factored into my thinking. More importantly, I could launch into a
discussion of the major chart structure and the long-term picture which is developing and which is
framed by the red trendlines. The implications are for a major move. The chart of the CRB metals index,

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Stocks & Commodities V. 4:8 (299-300): Letter to Jake by Stuart J. Pahn

which I have also enclosed, shows the formation of a giant apex. There is a great deal I would like to say
about this chart, but it would be beyond the scope of this discussion.
Wishing you the very best,

Stuart J. Pahn

Figure 1:

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