RISKS IN THE CURRENT MARKE CORRECTION, BUY ON STRENGTH NOT WEAKNESS

Friday, April 25, 2014

Market corrections are dangerous. It’s easy enough to step aside as the market drops but more difficult to avoid the temptation of jumping back in too early before the correction has run its course. Every correction is interspersed with rallies, sometimes quite impressive rallies that can lure us back in prematurely with so-called "head fakes". More money is probably lost from the temptation to buy cheap at the very bottom of the decline, and from the anxiety of missing out on the rebound, than from the decline itself.The most common mistake that traders make is to buy stocks on weakness, because they are cheap. Such action says that you know more than the market does, which is rarely true. The market has a way of humbling those whose egos tell them they are smarter than others. What is cheap is cheap for a reason. It may be a bad reason, a stupid reason, a reason we disagree with, but there is a reason. And what is cheap can get cheaper, much cheaper!A better strategy is to buy on strength, but only after the market as a whole has moved from the current correction phase into a confirmed uptrend. Even the strongest stocks will have difficulty swimming upstream against a market correction. And it takes more than a day or two’s rally to end a correction. There must be signs of institutional investors coming back into growth stocks with conviction. Markets don’t get very far on the strength of stodgy defensive stocks. They need the excitement of the newer and smaller high growth potential stocks. And we need to see a pattern of prices increasing on higher volume and declining on low volume as opposed to what we now have which is the opposite.But even after the caution flag is lifted and the market is in a confirmed uptrend, one must be careful not to chase after stocks that have bolted out of the gate and moved up so far as to become over-extended. Extended stocks will at some point pull back, and the more extended they are the sharper the pull backs will be. When a stock is extended the risk of a sharp pull back overrides the potential for gain.Successful trading requires careful study of the daily price and volume action to determine the timing and price level at which the risk/reward ratio is most favorable, and that means the point at which the stock is breaking out of a consolidation pattern with sufficient strength, big volume buying interest, to carry it upward to a new plateau. Buying too early and in the absence of sufficient buying interest or volume risks a breakout that will fail and plunge lower as disappointed buyers and holders that were looking to sell take advantage of the aborted move to dump their shares. Buying too late after the horse is out of the barn and has already galloped too far away risks being caught in the inevitable pull back.Trading is basically a game of chance. The odds are stacked against you because every human emotion impels you to make the wrong move out of either fear or greed. Careful study and dispassionate action can tilt the odds slightly in your favor. You will still be wrong about half the time, but if you have tweaked the odds slightly in your favor when taking a position --- and most important, have disciplined yourself to take losses dispassionately, relentlessly confining them to a targeted level --- it is possible to keep the average gain ahead of the average loss on a fairly consistent basis.