During Rallies, Don't Make This Mistake

Cramer: Challenge Every Stock You Own

Mad Money host Jim Cramer explains why he's often skeptical as the market surges; it's just one part of his "rally playbook."

If you're relatively new to the stock market, trading rallies can be somewhat counter-intuitive. That is, winners typically steal the headlines and therefore you'd think the best performers should command your attention.

And they should, but rallies are a good time to look at losers too.

Suspend the benefit of the doubt, the "Mad Money" host said Friday, assume everything you own is guilty until proven innocent. Focus on the worst qualities of your stocks, and emphasize the downside. Make each and every stock you own prove to you that it's worth holding all over again.

Largely Cramer says rallies are a chance to sell stocks, not buy them.

So the tougher you are on your portfolio, the better chance you have to lock in gains when you have them, he said.

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Also, Cramer said new investors need to remember that gains can make stocks incrementally less attractive. Why? Because price goes up.

Huh?

"When share price heads north, the risk-reward changes," Cramer explained. Here's an example.

Let's say you bought Texas Instruments at $25 and you thought it could rise as much as $9 and trade $34. Conversely you thought the downside was $22, a drop $3 . Your potential upside at the time you established your position was three times the size of the potential downside — a great risk-reward ratio.

However, if TXN only climbed $4 and then stalled, that ratio changes. Under your original premise the stock could have $5 left to go. But using the same downside price target there's the chance it could drop $7.

That makes the downside more significant than the upside.

In that scenario, Cramer said you may want to 'ring the register'. And you can use a rally to do that.

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Getty Images

Traders work on the floor of the New York Stock Exchange on December 10, 2012 in New York City.

What's the bottom line?

It's easy to get swept up by a rally and buy due to the euphoria of the moment.

Instead, "Give your stocks a hard time," Cramer said. "Hold them to a higher standard and ring the darned register on the names you like the least and the ones that are up the most."

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