The trend is your friend
If you have been trading in the market for a period of time, most likely you have heard of the axiom above.
If the trend is up, buy on pullbacks, or short-sell on bounce up if the trend is down. Generally, this is a very effective and sound plan for trading trends.
However, extremely strong price moves (especially parabolic move) can be an indication of a climax. Most of the time, this will end the current trend and lead to a trend reversal. Thus, it is important that you are aware of this price pattern, so that you are not caught on the wrong side of the market.
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The chart below shows a classic example of a selling climax that ended the downtrend (at least for the short-term) on Gold.
A naive reader might read this price action as extreme weakness and could be waiting eagerly to short again should price bounce up again thinking: “I missed this move… never mind, I will wait for price to retrace and short again”
However, I viewed it as a potential selling climax as the sell-off is extremely steep in a very short period of time. It is not the usual pullback. So traders should not be thinking of short-selling on pullback (as shown on chart as red circle zone)
At some point, the last seller who wants to sell has sold. If everybody has sold, who is left to push the price even lower? There isn’t any more selling pressure underneath the market as the supply has subsided.
In fact, traders who shorted near the bottom are now the the ultimate weak hands. And as soon as the trend starts to reverse and price starts to go up, they will have to cut their losses (buy-back). Their buying pressure will add fire to the fuel and price goes even higher.
In this case, after the climatic sell-off when Gold’s price hit a low of $1,180, price started to reverse back up, trapping short-sellers who shorted at pullback (red circled zone). Please note that a seemingly climatic pattern does not justify to initiate a counter-trend position (in this example, long Gold) because we never know whether it is an absolute bottom. But it serves as a very good signal to exit your current position if you hold a short position (or at least exit partially).
In conclusion: If it looks like a climatic price movement, do not trade in the same direction on the subsequent pullback.
Note: My personal view is that Gold is still in a long-term downtrend, potentially hitting $960/oz in the near future (based on Hu Li Yang‘s half average theory, 二分之一平均法). I am writing the above posting from a short-term trading perspective.