by Alexander Green, Chief Investment Strategist
Monday, October 12, 2009: Issue #1113

If you walked into a department store and saw a fabulous cashmere sweater marked down from $375 to $199, you might be tempted to buy it.

And if you saw it priced at $99, you might feel you were getting an irresistible bargain. Perhaps you are.

But stocks are not sweaters.

A good trader doesn’t average down – that is, buy more – as a stock plummets in price (although there is one exception to this rule, as I’ll explain in a moment).

Whenever you see a stock that is plunging in a flat or rising market, it’s a warning sign that something is wrong.

Why You Shouldn’t Try to Catch a Falling Knife

You may not know what the problem is that is causing the stock to fall.

• It could be that sales are down.
• Perhaps the company has lost a major customer.
• Expenses could be rising unexpectedly.
• A new competitor has emerged and is taking market share, or driving down profit margins.

You may not know the reason for sure until the company makes some kind of public announcement. But by then, the stock could be substantially lower. Why do shares decline before any corporate announcement? Because bad news often filters into the market through customers, suppliers, employees, competitors, or analysts.

As a rule, a stock taking a swan-dive in a rising market is no blue light special. Averaging down on a losing position has the potential to leave a short-term trader throwing good money after bad. Ask any shareholder of Lehman Brothers, Bear Stearns, or AIG.

However, there’s an exception to this rule…

The One Time When You Should “Average Up”

The exception is when a company reports superb results – outstanding growth in both sales and earnings – but the broader market is declining.

When investors get scared or nervous and the market averages plunge – taking shares of healthy, growing companies down, too – that’s the time to buy these companies on price weakness.

For example, dozens of stocks in our Oxford Club and VIP trading service portfolios have scored big double- and triple-digit gains since we bought them during the market meltdown in the fourth quarter of 2008 and the first quarter of this year.

And since this rally has been relatively smooth, as well as historic, we haven’t stopped out of many positions. Most of our shares are still rising.

However, good traders don’t just let their winning positions run. They also add to them, a technique called “averaging up.”

The Best Way to “Average Up”

This may go against every frugal bone in your body. After all, averaging up means increasing your average cost per share.

But it may also mean that you have a greater amount of money invested – and your final profits should be larger.

On your initial purchase, a good rule of thumb is to put in half the amount of money you intend to invest. After the stock rises 5%, put in another 25%. Assuming it rises another 5% – or approximately 10% from your initial entry point – invest the final 25%. Then run your trailing stop based on your average purchase price.

The advantage of this system is that you have less money invested in stocks that don’t pan out. And more money invested in those that do.

Over time, this will be a big factor in determining your success as a trader.

Good investing,

Alexander Green

View original at: Investment U

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