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I Wasn't Wrong Buying DUST This Week -- I Was Just Early. Nope, I Was Wrong. Now What!

|Includes: DUST, VanEck Vectors Gold Miners ETF (GDX), GLD, NUGT

When the triple Inverse ETF DUST rallied from $65 to $110 a couple weeks ago, several people remarked to me, "This DUST ETF rallies every day. Why don't you just put all your money in this thing and trade nothing else?!" Well, this week you found out why you can't put all your money in DUST.

I Was Not Early.....I Was Wrong......Now What!

I just rode through a horrific selloff in DUST this week, while missing a great easy rally in NUGT. I was not early, I was just plain wrong. Now what do I do? Fortunately, I was very conservative in my trading and can recover. But it will take a plan. First let me say that I trade DUST in my IRA because trading in this speculative leveraged stock is an extreme gamble, just like life. I never plan to retire and will not touch my IRA until forced to withdraw funds so I am not too worried about whether or not I build a nest egg. My wife is conservative and her IRA should take care of her. We have three successful companies and figure we will survive just fine even if I blow all the funds in my IRA. I don't want to blow it because then I would lose out on the fun of trading. Therefore after a big drawdown, I always get serious and build it back up. To ensure I don't blow it, I need a plan.

Setting Up a Fun IRA Trading Account That Does Not Go Broke Playing DUST Or NUGT, Etc.

Suppose I had $100,000 in my IRA. I would only use 40% of the funds for speculative plays like DUST, or $40,000. Of the $40,000, I would put an initial $20,000 in DUST and keep $20,000 for backup. Why? Because DUST is triple leveraged. If GDX goes up 10%, then DUST falls 30%. If GDX has a rally of 33% straight up, then I would lose 99% of my investment in DUST. You cannot recover from that loss without adding more funds. The extra 20% is there to bail you out.

What is very deceiving while playing DUST, is the fact that it is triple leveraged. So if you buy 100 shares of DUST, you are going to gain or lose as if you owned 300. Owning 500 shares equals 1500 shares of movement. That is really scary! The recent low in GDX was $24 and it has rallied to nearly $31 today, for a gain of 29%. That is pretty close to 33% which is a near wipeout for DUST traders who bought at $110. Thankfully, I was smart enough to buy DUST at $60 average instead of at the top of $110.

Now Where Is My Breakeven

According to my article that you can find here, I was to buy from $70 to $50 so my average price would be about $60. Investing $20,000, I would own about 300 shares at this point. Since we closed at $46 yesterday, August 15, 2013, I need a rally in DUST of $14 or 30% to get back to $60 and let me out. For DUST to rally 30%, then GDX has to fall 10% from the $30.40 close, or to about $27.36. (Note: because I daytrade, my average price is lower than $60, and I only need GDX to fall to the low $28s).

But what if GDX keeps going up? At what point will my 300 shares of DUST be turned to, well, dust?! Based on the $27.36 breakeven price of this illustration, that is where I am positioned. From that price, I can figure a 33% gain in GDX which would pretty well wipe out my initial investment. It works out to about $9.03, so adding that to $27.36, if GDX would rally straight up to $36,69, my initial investment would be pretty well all gone. At that point, DUST would be trading at about $18.50. But remember, I have backup money! At $18.50, in DUST, I could invest my backup $20,000 and that would now buy over 1000 shares of DUST, instead of the 300 shares purchased at $60. Averaging the two together, that gives a total of 1300 shares of DUST with an average price of $28.07. Now suppose GDX falls from $36.50 back to support at $30, a drop of 17.8%. Tripling that move in DUST, then DUST would go up 53.4% or to a price of $28.38. Since my average price is $28.07, then I would have my money back.

How High Can GDX Move On This Rally?

I looked at a three year weekly chart of GDX that you will find here:

What you see is that in 2011, GDX liked to rally from about $50 to $65 which is a gain of about $15 or 30% before losing it all. In 2012, we have a major move from $40 to $55 in GDX, a gain of $15, or 37.5%. In 2013, we have bottomed at $22.50 and recently at about $24. If you figure a $15 move from the low of $22.50, you get $37.50, a gain of 62.5%. That is pretty extreme, but not out of the question. If we rally from the recent low of $24, to $36.50 in the above illustration, that would be an increase of 52.5%, which is probably about the worst case scenario. In fact, recent rallies to $30.58 and $31 turned GDX back, and today's high of $30.94, might be enough for the time being. On today's dip below $30 in GDX, I dumped out of the shares I bought at $28.50, leaving me only 60% invested with my initial funds. I will use the freed up funds to buy on dips and then sell out on rallies to lower my average price further.

What the above illustration really shows is that I cannot add any cash beyond my initial $20,000 until that money is pretty well tapped out, with GDX trading above $36. At that point, I can say that the original investment is toast and it will then be time to employ the extra cash to try and get my money back on a move from $36.50, back to support at $30.

Again, this is an illustration. In practice, I am a day trader and when I see support broken during a hard down trading day, I try to dump at least half of my position, and then buy it back when we stabilize at lower prices. This greatly helps reduce my average price without adding capital to the position. Also, if I have 300 shares, I can scalp from profits by selling 50 to 100 shares on a rally, and buy them back after a $1 to $2 dip back.

Another strategy to employ is to use extra cash sitting around and buying NUGT with it. With the big money made in NUGT this week, I would be looking a whole lot better on my DUST position right now. Of course that is hindsight.

Disclosure: I am long DUST.