Mad Money

During Rallies, Emphasize the Downside

Cramer’s first rule for trading short-term rallies is this: Be as hard as possible on your portfolio when the investors around you are in euphoric bliss over the market’s big move higher.

Suspend the benefit of the doubt, he said on Wednesday, 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.

Unless you own stocks that have dramatically outperformed the market, Cramer said, you should be borderline ruthless toward them. But even then you want to really drill down on your reasons for owning them. Because as soon as the share prices shoot up, a piece of your portfolio just go more expensive, and that makes your holdings less desireable.

Why? Because price matters. And when the share price heads north, the risk-reward changes. Let’s say you bought Texas Instruments at $20 and you thought it would either rise $9 or drop $3. Your potential upside is three times the size of the potential downside – a great risk-reward ratio. But if TXN climbs $4 during a rally, that ratio changes. Now the stock may have just $5 left to go before it reaches your price target, but there’s the chance it could drop $7. That makes the downside more significant than the upside, and you’re going to want to sell. Use the rally to do that.

Another thing to keep in mind, and Cramer said this earlier in the show, is that 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. This probably will go against every instinct you have, but you have to act in spite of your emotions. You need to reevaluate your stocks and demand a lot more from them than you ordinarily would.

This is how Cramer grades his stocks so he’ll know what to sell when a rally hits: Each name is given a grade of one, two, three or four. The ones are stocks he’d buy at their current price. Twos are stocks he’d buy if they pulled back. Threes are stocks sell at a higher price. And fours are stocks he’d want to sell period.

During a rally, prices go up. So ones become twos, and threes become fours. He sells the new twos, assuming he’ll get a chance to buy them back at lower prices in the future. And then he sells the new fours because he got the price he wanted.

This is just a basic approach to selling into a short-term rally, but the point here is to not get caught up in the buying. You don’t want to get swept up in the euphoria of the moment.

“Give your stocks a hard time” instead, Cramer said, “and then get into sell mode.”

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