May 2nd, 2012

“Trading Around a Core Market Direction View”

Jim Cramer did one of his “I’m going to teach you ‘homegamers’ how to trade the same as I did when I was in my multi-million dollar hedge fund years ago” shows.  The point at which I was surfing through the show was when he was answering a viewer’s question about when to sell a winning position?  His answer was that if the viewer didn’t want to act like a novice trader, he needed to “trade around your core positions”.  But what does that mean?

According to the show’s transcript, the concept involves:

  • start by picking a stock about which investor has an opinion. They should believe the stock could go higher over the long term. It should be a great underlying company with a stock that could get tossed around by market volatility, but nevertheless has potential to push higher in the long haul.
  • Each time the stock jumps 3 percent, the investor sells 16% to make some profits and continue selling shares as the stock advanced until the position was reduced by 50%.
  • At that point, the investor would wait for the stock to be knocked down, so they can buy more shares.  When the stock declines 6%, the investor would buy back 16% and continue buying in increments until the original position was repurchased.

According to Cramer, “A lot of people think that trading is incredibly exciting and it can be, but if you’re good at trading around a core position, you should be pretty bored because all you’re doing is watching the stock move and trimming or adding to your position accordingly.”  It sounds simple enough but, I’m sorry, the market isn’t that accommodating and unless your portfolio has less than a handful of stocks to follow it sounds like just to much trading.

Rather than watching the daily trading patterns of individual stocks, I like to “trade around a core position” where the core position is my total portfolio and the trading is making essential a single investment decision: “How much should be invested and how much cash should remain at the present time.”  What I’ve found is that investing is essentially a risk and cash management strategy.  There are times when you should be fully invested (or more so when using margin) and other times when you need to be 100% in cash.

I arrived at that conclusion by watching the action of individual stocks and my total portfolio as compared with the S&P 500 Index.  What I’ve found is that the odds are that stocks tend to follow the market’s general direction; they may vary in degree but the direction of the movement is usually in the same direction.  Regular readers are familiar with a saying that I’ve quoted here often: “50% of a stock’s price movement can be attributed to the overall movement in the market, 30% to the movement in its sector and only 20% on its own.”  Here are several examples from today’s trading.  The blue line is the S&P and the black is the stock on a on minute chart:

  • TKR
  • EOG
  • CE
  • ALGN
  • LLTC

I could go on and on but you get the picture.  When the market goes up, most  stocks will go up; when the market goes down, individual stocks will likely go down.

Bottom line, it’s probably more important having a good sense of what the market will be downing this minute, this morning, this week, this month or the next six months than it is trying to predict what individual stocks will be doing.  Rather than timing sales of individual stocks by the price action of that stock,  it’s probably more worthwhile tying that transaction to what the market will be doing.  Rather than selling a stock because it’s gone up 10%, 20% or even 50%, you should time the sale to the health of the market or industry group.  Conversely, time purchases according to whether the market will be firm or if it’s on the verge of correcting or reversing.

“Trading around a core position” can lead to either major opportunity costs in lost profit or real losses from buying into a deteriorating stocks or market.  Figuring out market direction is probably time better spent then finding stocks with the most ideal stock charts.  When the market is rising it’s more important to throw money at a diversified portfolio (or even into index ETFs) than trying to find “the best” stocks to buy; when the market is falling, getting out of the way is more important than trying to decide which stocks will survive the downdraft and which won’t.

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