By Louis James
Casey Research

Whenever gold and silver hit a correction, those are the times that try men’s souls. But they are also a classic case of making volatility our friend.

And there should be terrific bargains ahead on great stocks, if the market corrects from recent highs. It enables you to go long at prices as low as, or sometimes even lower than, those paid by speculators who picked winning plays early – but with the advantage of hindsight about the results of those companies’ exploration and development efforts. You get a combination of lower risk and lower prices.

How cool is that? (As my children say.)

This is exactly the kind of environment in which we were able to scoop up shares in companies like Osisko, International Tower Hill and Detour Gold for tiny fractions of their current prices, back in the crash of 2008. I’m not saying we’ll see another crash like 2008 this year – but we might, and eventually will, if Doug Casey is right about what’s in store for the economy. But making money in our market is all about buying when prices are low, taking profits when prices are high, and building your portfolio for the eventual Mania Phase that will signal our exit and shift to other markets for a time.

Buying in Tranches

As we keep emphasizing; we’re speculators, not gamblers. We almost never go all in or cash out completely. We seek to balance risk and reward. The primary tool we have for doing that is our strategy of buying in tranches. Generally, that means buying 20% of your desired position in a first tranche, 20% more in a second tranche, and 60% via stink bid when the market fluctuates wildly – which our market often does.

Yes, this strategy can be frustrating while the market is rising, because it can leave you with only 20% of your desired position while a stock takes off. However, it also means that you’re never exposed more than 40% of your ideal position unless you’re given a dirt-cheap chance to buy. It takes patience and discipline to only buy large blocks when they are on the deep-discount rack.

An Exercise

Consider this scenario: You buy 20% of your ideal position in a gold stock you like, and it keeps rising: 10%, 20%... Hard not to wish you hadn’t taken a much larger tranche! Now there’s a big market fluctuation: gold drops 10%, your stock drops 40%. You buy a second tranche 10% below your first tranche. Now you have a more substantial 40% of your ideal position averaging 95% of what you originally paid. The market recovers, and the next time the shares are 20% over your original entry point, you have greater profits on a larger block. If you’d bought 100% of your ideal position, you’d only be up 20%, and you’d likely have sweat bullets when prices were falling.

At this point, if the company makes a major discovery, or the stock goes vertical with the market for other reasons, you have substantial exposure to that upside – chalk up another win. Maybe it could have been bigger, but it’s still a win, and one executed in a way that exposed you to much less insomnia along the way.

But suppose, instead of the market shifting into the Mania Phase, there’s another major market meltdown of 2008 proportions. Gold drops 30% (which, it’s worth noting, would still be above $1,000, a level at which the better projects still make a ton of money), and our gold stock, because it’s a good company, drops 75% – shakier companies drop more than 90%. From 120% of our original entry point, our shares are now at 30%. Nothing wrong with the company, so we buy a larger block, 60% of our ideal position. Maybe we buy even more, if we really believe in the story and the company is cashed up enough to weather the storm – at 30% of our original entry point, why not?

Let’s say the shares initially cost $1, and our ideal position is 10,000 shares, to keep things simple. We now have:

1st Tranche: 2,000 shares (20%) at $1.00

2nd Tranche: 2,000 shares at $0.90

3rd Tranche 6,000 shares at $0.30

Average cost basis ($2,000 + $1,800 +$1,800 / 10,000 shares): $0.56

Now the broader market realizes that gold is the one safe haven it can count on, and the real Mania Phase of this bull cycle kicks in. Our good company delivers on its discovery potential, or achieves production at record-low costs, and joins our “Ten-Bagger Club” shooting up to 1,000% of our entry point. With our cost basis of just over half of our original entry point, we’re actually looking at a much larger win: $5,600/$100,000 = 1,685.7% gains.

That’s more than half again what we would have gotten had we gone all in at the original entry point, and with an incomparably smaller amount of heartburn before payday. Though, in reality, people who went all in and saw those positions decline by 75% would be more likely to be forced to sell by margin calls. Or they would sell out of sheer panic as share prices plummeted – and then would miss the rebound, chalking up losses instead of 17-baggers.

Could this really happen?

In a word, yes.

In a few more words: this is exactly what I think is most likely to happen to our best picks, with even larger gains quite possible.

We all know that the problems that caused the 2008 meltdown have not been addressed in any meaningful way by the governments of the world. All their actions have been bandages trying to staunch hemorrhaging from deep wounds to vital economic organs – if not actually worsening those wounds with ill-advised procedures. The politicians haven’t the will nor backing for the drastic surgery needed, so they make a public show of trying to stop the bleeding, and the crisis under the surface deepens.

Think about that for a moment. Really. Right now.

Think to yourself, calmly, and let your mind savor the thought:

“I only buy large blocks of shares when I can get them dirt cheap during a major fluctuation in a bull market.”

Now try this thought experiment. Say to yourself:

“I buy all I can afford of stocks I like before prices get away from me!”

Now, which of these two thoughts do you think will help you sleep better at night?

Bottom line: remember that you must balance greed and fear, risk and reward. You cannot just focus on reward, or you’ll lose your shirt. Nor can you let fear of risk paralyze you, or there’s no point entering the arena. Understanding this, and a little meditation in search of understanding yourself as an investor, goes a long way.

I think of this as the “Zen of Resource Speculation.”

Don’t let those who think the gold market has topped spook you. All the harsh economic realities underlying the gold bull market (and all things tangible, in the end) are still there, and harsher than ever.

Stay the course.

Louis knows what he’s talking about – last year his select junior exploration stocks beat gold’s performance by three times… and outpaced the S&P 500 by 8.4 times. And 2011 is shaping up to be just as good, if not better. Learn more here.

© 2011 Casey Research

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