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On Prudent Speculation

|Includes: SPDR Gold Trust ETF (GLD), NUGT, TBT, TZA

Prudent speculation sounds like a contradiction in terms, but it's not. The reason is that speculation need not be an "all or nothing at all" commitment. Rules that place limits on one's losses limit speculation to a quick trade when the market goes against you. You needn't lose most everything on one decision, as is usually assumed about speculating, but you can make a small fortune if your gamble pays off.

I remember Al Frank of the Prudent Speculator, who used to make the point that a prudent speculation is one where a stock has the potential to go up twice what it might go down. I specialize in gold, silver, and resource stocks and long ago learned to apply Al Frank's tactics to speculative gold stocks. For example, a "penny" stock selling at a dollar or so may have the potential to move up ten-fold. So in a spec like that I don't use stops. I know my downside risk and am prepared to lose my entire investment, or close to it, for the potential of huge gains.

One thing to keep in mind with penny stocks: it's really hard to get out of a position if there's bad news and everyone's selling. A stock selling for 10 cents, for example, may fall to 3 cents a share in seconds if everyone tries to dump their shares at the same time. The stock may very well be halted if that were to happen and when it finally re-opens can be worth nothing. So, you have to look at your investment as a total write off if the market goes against you in speculative stocks.

But on the other side of risk is reward. Gold Corp was a penny stock at one time, then hit massive amounts of gold and became one of the largest and richest gold mines in the world. What was a penny stock became worth 40 dollars in a very short time. So, I am a holder of my core position of spec stocks, all of which have the potential to double or triple at the minimum.

Trading is quite different. It's also speculation. But you can do it prudently. You can control the process. One way is with rules like "cut losses quickly and let profits run". I go into trading with the assumption that I will make more bad trades than good ones. Those are the odds. To put the odds in my favor, I trade on news developments as they're breaking and look for money coming into the stock. That usually leads me to buy on the rise and not the dips.

As markets change, I change, and even my rules may change. Today we have a choppy market. Choppy markets tend to chop up traders. You get stopped out all the time. That's costly. But I've found that in the long run, trends reassert themselves and losses are made up. Over the years the stock market and the gold market have gone up. I entered the stock market in 1968 when the Dow was 776. The Dow today is 16500; and I bought Homestake Mines, the premier gold mine in 1968 when gold was at 35 dollars an ounce. Today gold is 1300 bucks. The thing that both gold and the stock market have in common is inflation.

Inflation is a way of life. Gold mines come and go, and so do many popular companies, but the one thing that stays and always goes up is the price level. Enter margin. It's not enough to see your stocks go up with inflation. That's an illusion. You need to beat inflation to really profit. One way to do that is with leverage.

A lot of people shun the use of margin, yet no one ever questions the fact that most people use margin to buy their homes; they leverage their homes to the tune of 5 or 10 to one. Stocks can only be margined 2 or 3 to one. If you use stops to exit a trade quickly if and when it goes against you, where's the undue risk? I call that "prudent speculation".

Today you can gain leverage even without margin by using leveraged ETF's like NUGT for gold stocks that goes up at 3x's the rate of the underlying stocks it tracks; or TZA which shorts the market at the same rate. You can buy TBT that tracks long-term interest rate at 3x's their pace. Most call these instruments extremely speculative. You can use 10 times the leverage to buy a house which you can't easily liquidate and may get stuck in for years, yet you are discouraged to use ultra ETF's which you can liquidate in the blink of an eye and have total cash at your disposal instantly.

I'm for prudent speculation. It's not for everybody, but it does serve a purpose. It allows you to hedge your portfolio, and it allows you to make large amounts of money in a short period of time. I would not have been able to get back to where I was before the financial crash if I didn't have margin and ETF's to leverage back then. I was back to personal all time high's in 2 years where without leverage it would have taken me 5 years to accomplish the same thing.

Trading and having a good strategy is all well and good, but probably the most important factor in the ability to make money in investing and trading stocks is knowing when the fundamentals change: knowing whether we're in an inflationary or disinflationary period; knowing whether we are headed for boom or bust or stability; knowing whether interest rates will rise or fall, or the dollar for that matter. I went 100% to cash in 2011 at the top of the gold market and avoided being trapped in falling stocks. And I went all-in to gold stocks since the first of the year assuming that this year will be the turn in gold. If I'm right, the small losses I've incurred will be of no importance compared with the money that can be made on the way back up in gold.

Investing, trading, and especially speculating isn't easy - if it were, everyone would get rich. It's a discipline, and as such will yield good results if followed.

And that's the point. Invest, trade, and even speculate -- but Stay disciplined.

Paul Nathan (Paul Nathan's Market Update)