If you are a trend-follower, the market's volatile and choppy tendencies in 2011 have made for one of the most difficult environments for catching profitable trends. In this market environment, any trend that begins to develop tends to be short-lived.
For example, our market timing model at www.selfishfishinvesting.com did catch the steep drop in early August with a sell signal on August 2nd, as well as part of the market’s steep ascent in early October. But these profitable trend signals have been sharp, short affairs, and any gains made during such movements end up being whittled away when the short-lived trend turns into a “chop zone.”
Thus, we think investors can best avoid dying the “death of a thousand cuts” by taking a slower pyramiding approach in this market so that if a trend signal proves to be false, risk is kept to a minimum.
For example, for fundamentally strong, fast moving stocks (Relative strength >95), one could add a fixed % (say 20%) to one’s initial position each time the stock advances 10%. More conservative investors may want to only add 10% each time the stock advances, say, 20%. For more conservative investors who wish to invest in stocks not moving quite as fast, one could add 10% each time the stock advanced 10%.
One would then set a trailing stop which is a stop that rises as the stock rises in price, thus locking in gains on a profitable buy or minimizing losses on an unprofitable buy. This puts investors in the position of forcing the market and/or their stocks to prove themselves before committing further, precious capital.
Remember, legendary investors such as William O’Neil, Jesse Livermore, Gerald Loeb, and Bernard Baruch always looked to pyramid into the next leading stock. Leading stocks can trend for many weeks if not months. The big money is made by finding the best then pyramiding into the best.
The advantages to this strategy are three-fold:
1) Leading stocks are the ones that often move up hundreds of percent in a bull market in extended upside trends. This is where the big money is made. As Jesse Livermore used to say, it is the uncommon man who can “be right and sit tight.” But we cannot know ahead of time which stock or stocks will be the big winners. Pyramiding allows the investor to let the stock prove itself on a price basis before adding to their position.
2) Smaller losses result if the buy proves false since it is unlikely one would even have had the chance to pyramid on a false buy since the stock never would have advanced enough, thus their position size on the loss would be smaller.