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you are wrong-and your exit point, and then calculating the following ratio:

Purchase Price - Exit Point

Risk/RewaKi =

Target Price - Purchase Price

This ratio expresses technical risVreward in terms of maximum probable losses versus probable potential profits. Properly considered, risVreward from any dimension is always a ratio of probabilities. Where it gets tricky is in establishing a way to quantify probabilities when dealing with other than technical factors. When assessing risVreward, a whole range of information, including both technical and fundamental economic principles, comes into play. Let me illustrate how to com bine these factors by examining a position I took in gold in October 1989.

I bought gold on 10/27/89, the day the market gave me a confirmation of a 1 -2-3 change of trend in the intermediate term by breaking above the previous rally high of 376.70. At this point, t here was also a probable change of the long-term trend by the same critetia-both the break in the trend line (condition 1) and the test and failure of the previous low (condition 2) had already occurred.

In the intermediate term, because I had a confirmed change of trend, the market would prove me wrong if prices fell back through the buy spot, so I set my mental stop slightly below that point, at 375.70. The target point in the intermediate term was the 7/25/89 high of 399.50. So my technical risVreward ratio was:

376.70 - 375.70 = 1 399.50 - 376.90 22.6

When I looked at the long-term chart (the weekly bar chart), things looked even better in terms of the potential levels gold might reach. There, I could see a targe t price (resistance) at 433.50. After that, there was another resistance point at 469.50, one at 502.30, and if I looked at an even longer-term chart (at a monthly bar chart), I saw prices in the 800 range. I wont bother calculating the risVreward of eac h point for you, but you can see that the ratios were extremely favorable.

From a technical standpoint, trades this obviously good dont come along too often. The only problem is to figure out the probability of success and establish your entry and e xit point(s). What do you do: Play the intermediate term, or buy and hold for the long term?

To help answer this question, what I did was to assume the most conservative case. That is, since the intermediate trend had already changed by definition, I assum ed that this would be an intermediate trend lasting from three weeks to three months. Next, I went back in history to 1981 and tabulated the extent of every upward move in gold lasting from three weeks to three months.

I found that, of 18 such moves, the minimum movement was 9.4%, the maximum movement was 68.8%, and the median movement was 15.2%. Based on the low of 360.60 in the December futures, this told me that there was a very high probability that gold would rally at least 9.4%, which is a change of $33.90 per ounce, to a price of $394.50. In addition, it told me that 50% of all moves within the last nine years rallied more than 15.2%, which for the December futures would be $54.81 per ounce to the 415.40 level

What does all this tell you in terms of asset allocation? The extremely low technical risVreward factor, the high historical probability of the move going to at least 394.50, and the fundamental factors all supported taking a long position on October 27. When all the factors are strongly in fav or of a position like this, then it is time to become aggressive.

This means that, in the early part of the move, you should use optimum leverage. My choice was to put approximately 10% of all my managed portfolios in gold by buying calls on the gold futures, calls

on some gold stocks, and some of the gold stocks themselves (the stocks for my less risk-oriented clients). Once prices broke through the 400 level, I began scale-selling at a very substantial profit, with the intention of holding a smaller, long-term position, still highly leveraged, until the market proved me wrong.

Why did I sell at all? Because after prices reached the intermediate target level, the risl0"eward of holding the position increased substantially. The justification for staying involved at this point has to be a conviction that the long-term trend will keep going up. I held a smaller long position with a portion of profits, and guess what? I was wrong and lost the money. Although I was dumbfounded at the fact that gold failed to sustain its rally, my principles of money management saved me. Let me tie this process directly to the principles of my business philosophy.

First, by using leverage and by picking a buy spot that allowed a small loss as an exit point, I did not expose capital to a high degree of risk. If, by some odd circumstance, prices had failed back below the trend change confirmation point, then I could have most likely closed the position with a loss of at most I to 2% on my accounts. Then, if it rallied again, I could still afford to take another position. In short, I set the trade up to preserve capital.

Second, when prices reached the target level, I took enough profits to lock in a substant ial gain in accordance with the goal of consistent profitability.

Third, I used a portion of profits to hold a long position for the pursuit of superior retums. I was wrong in the long-term call, but I still ended up net profitable on my overall pos ition. In my mind, thats successful speculating through smart money management. By allocating capital according to the risk of involvement, by setting preliminary exit points to lock in your profits, and by using only a portion of profits to pursue the larger gains, youll stay at the table even when you lose some hands.

Allocating Capital

Unfortunately, there is no simple formula to plug into a computer that will tell you the best way to allocate capital in the markets. For example, I cant take my historical data and buy the stocks that make up the Dow Industrial and Transports averages according to some linear risk relationship. To do so would be to defy the nature of the markets. What you have to do is make a judgment call based on the widest context of knowledge possible, combining all aspects of your knowledge to form your best estimate of coming events.

Suppose we were in a strong bull market that had already exceeded its extent and duration medians; inflation was at 2%; the world was at peace with no potential conflict in sight; corporations in general had little debt and high eamings; and every major country had a balanced budget, little or no debt, and operated on a free, gold based banking system. Nice thought, isnt it? In such a case, you would obviously want to be 100%o invested.

In effect, what you do is build a risk assessment scoreboard that tabulates all the driving market forces and weigh each factor separately to decide how much and in what way to put capital at risk. If you decide to invest at all, then you use the same facts as a context to choose those instmments that are most likely to achieve your goals.

What Ive said so far is all very general, so let me get more specific. When you are assessing the risk of being involved in the stock market, you have to ask yourself the following questions:

1. What is the long-term trend? Is it up, is it down, is it drawing lines, or is it changing?

2. How does the current long-term trend fit within the context of history in terms of extent and duration? Is it young, old, or middle-aged?

3. What is the intermediate trend, and where does it fit within the context of history?

4. What does Dow Theory say about the current market? Are there divergences? What does the volume tell you? Is breadth moving with the trend?

5. What do the moving averages say-buy, sell, or hold?

6. Do oscillators tell you that the market is overbought, oversold, or in the middle of a move?

7. What is the health of the economy?

a. Where is inflation and what is the Feds policy toward it? What are the levels of national, civil, corporated, and private debt? What is the rate of growth of credit availability as measured by free reserves? What is the rate of growth of the money supply? Where are interest rates? How are the markets receiving new issues of govemment securities?

b. How strong is the dollar relative to foreign currencies, and what is the likelihood that it could be debased? How strong are the yen and the deutsche mark and are those govemments likely to take action to protect them?

c. What is the prevailing attitude of the American consumer: produce and save, borrow and spend, or somewhere in between?

d. What economic sectors are strong? Which ones are weak? Are any stock groups driving the market, giving it the appearance of health when in fact the tide could easily tum at the slightest bad news?

e. What potential problems exist that could cause a sudden change of the economic climate?

8. What predominant fallacies exist that can be used to advantage, especially when the market changes?

Once you answer these questions, you then have the basis to decide when, where, and how much money to invest in the markets. And when you decide to make your move, youve got to do it in a very disciplined way. Thats where rules come in, the subject of the next chapter.

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