Buying on the way down...

Last night before I had to leave the house to go to a meeting I caught a few minutes of Cramer (the TV was still on CNBC from the morning.. really, it was). He was in the middle of a discussion on buying a stock each time the stock price went lower. He said if it drops a point then buy another 100 shares, drops another point go in even more, and on and on. What was completely void in his discussion was the topic of charts. Not once in the time I was watching did he say anything about long term trend support, support & resistance, etc. Nothing at all about the chart. He only said to keep buying as the price went down.

This has got to be the biggest and worst things I have ever heard him say. To me it is irresponsible to advise people to do that with their money. That is the wrong money management plan and is a potential disaster in the making for your capital.

Remember that the chart is our x-ray into the company. The chart tells us the health of the stock. For it represents all forms of money involved in that stock. It shows the big hedge fund money, it show the mutual fund money, it shows the investing public money (you & me) and everything else in between. The chart does not filter out anyone. It displays all monies involved day to day in the stock. So the chart is the most important tool we have in our trading arsenal (second only to our own grey matter) to read the health of our stock.

When you have a chart that has been trending up for many years and can be identified by major trend lines on weekly and monthly charts then that trend is your key to knowing when there is a significant shift in the people moving money in and out of that stock. In chart analysis the break of a major trend line is the most significant marker of a change. Pullbacks to moving averages, breakouts from consolidation, triangles, etc. don't measure up to the importance of a major trend line break. A trend that has been in force for 5 or more years for example is paramount in its significance to the health of the stock.

So when Cramer started speaking about how to keep buying when a stock starts dropping is irresponsible without addressing limits and charts. If the uninformed investor who watches his show decides he is going to do as he suggested and he has a stock in his IRA that has been dropping and he decides to keep buying more (based on Cramer and his buy, buy, buy idea on the way down) what is to prevent this investor from buying more shares of a stock that is in serious trouble? Without consulting a chart and understanding some basic technical analysis concepts this investor will just throw more money on a potentially already bad stock. When all is said and done this poor investor (and he will be poor when his investment turns to nothing) will be wondering why years later he has not made any money, or even worse has lost money.

Mr. Cramer has made it clear on numerous occasions that he does not believe in technical analysis. As he so demonstrated one night when he stood on his head and said he was a "head and shoulders" pattern and mocked people who study the charts. Well if he ran a hedge fund years ago then he had to of used charts and understands how to read them. So why would he now boo hoo charts and technical analysis? Guess only he knows that answer. Perhaps he does not want to give any power to the viewers to see through his recommendations???

The point I'm making here is that no one should ever buy on the way down unless they fully understand the chart and can identify the major trend lines. This way the investor could tell if the drop in price was nothing more than a sector rotation drop or some other minor cause and can say that the stock is still healthy (because it is still above the major trend support). And I should add that adding to your position is only acceptable for long term investments. But the chart still takes priority in the decision making process, even with a long term investment. I feel bad for the investors who blindly follow Mr. Cramer and don't take the time to understand for themselves the risks of buying on the way down. Without knowing the danger signs that a chart can signal then that person could be buying more shares of a stock that is on its way to the stock cemetery.

Did you know that during the Enron collapse some major investment analysts were advising their clients to add more shares, to buy more! Yes, it is true. While the smart investors who looked at the chart knew it was in trouble and got out before losing everything.

I want to quote another passage from one of William O'Neil's books (founder of Investors Business Daily)..

One of the most unprofessional things a stockbroker can do is hesitate or
fail to call customers whose stocks are down in price. That's when the customer
needs help the most. Shirking this duty in difficult periods shows a lack of
courage under pressure.
About the only thing that's worse is for brokers to take themselves off the
hook by advising customers to "average down" (buy more of a stock that already
shows a loss). If I were advised to do this, I'd close my account and look for a
smarter broker.
Everyone loves to buy stocks; no one loves to sell them. As long as you
hold a stock, you still have hope it might come back up enough to at least get
you out even. Once you sell, you abandon all hope and accept the cold reality of
temporary defeat.
Investors are always hoping rather than being realistic. The fact that you
want a stock to go up so you can at least get out even has nothing to do with
the action and brutal reality of the market. The market obeys only the law of
supply and demand.

My advice is to never average down. If you have a trade that is not working then why throw more money into the fire. If the trade is not working then you should not be in it anyway. Because your money management rules would have you out of the trade when it went the wrong way. Protect your capital! This is key to winning. Never deviate from your stop loss rules, ever!