Follow Through Day at Risk

The follow through day we saw in my last blog is now under pressure. If the market doesn’t turn up quickly then the follow through day will have failed. Distribution days have occurred since that follow through day which is not a good sign. Readers may have taken a small probing position (important part of money management as discussed in previous blogs) and have been unable to add to their positions to date. You may even have been stopped out. I would suggest not talking new positions at this point unless the follow through day shows it is going to succeed. Remember the mantra every bull market starts with a follow through day but not every follow through day leads to a bull market. In fact only 75% of follow through days are successful (still very good odds).

Today I thought it appropriate to have some fun. I hesitated to use this example since people will say it’s easy in hindsight. Please please be aware I am not or have not recommended the following stock I just wish to use it as an example of money management and yes it is in hindsight. It is VERY important to start with small positions then build them up (probing positions). If the stock market turns down at the start you then lose very little. If it turns down later when you are accumulating much larger positions you have choices on how to proceed but with good money management cannot lose. Please read on.

Suppose you bought LCUT one year ago at point 1 with one unit of money. Remember a unit is a very small amount that leaves you comfortable if you lose 10% of it. Now after that initial purchase at point 1 you place a 10% stop loss in case it fails. Note as it rises you buy more stock at point 2, a second unit. By the way these numbers are not sequential I am using them to show how many units you own. So at point 2 you own two units. After the second purchase you raise your stop to the average buying price to break even if you are stopped out, now you cannot lose. At point 3 you make another single unit purchase so now you own 3 units. This time the break even point (average buy price) will not have moved up as much. Its like if you own 100 units and you buy 1 then your average price isn’t affected much. However the stock price is now moving further up away from your average price so you are less likely to be stopped out.

Notice after every consolidation as the stock breaks out to the upside I buy another unit and another and another. At point 6 we own 6 units and the stock consolidates then at point 8 it breaks out and jumps up again. Notice I bought 2 units since we already own 6 units I buy 2 and call it point 8 since I own 8 units. If I own 6 and start buying 2 units at a time I am not affecting my average buying price by much so it still doesn’t move up close to being stopped out.

I now keep buying 2 units at a time until I own 20 units. During this fast ramp up I could easily have increased my buy size to 3 or 4 units at a time and still not have brought up my average buy price by much. Now not long after point 20 where I own 20 units with an average buy price much lower things are starting to look not so good. The stock gets hit with some high volume selling so I sell half my holding and at point 10 I now only own 10 units. I have just locked in a very nice profit, my average cost and stop sell point is till very much lower. Now if the main indexes are doing badly and you have a strong stock you will generally find strong companies start moving sideways, they resist any sell off. In fact at point 12 you have bought another 2 units and the upside climb has resumed after a long sideways consolidation. The stock did not break any lower or go up for a while so you sit tight. When it broke out to the upside on volume you started adding to those 10 units again. You now own 12 units and look like your about to go to 14 or 15 units. This is how you stay with the leaders even in down markets.

Imagine if you owned a few companies this way. The stocks that move sideways you can start selling off a little and moving that cash into the companies that are climbing.