How To Re-Enter A Rising Market

Includes: DIA
by: Jamin Chen

One of the readers, northhills24, of my latest article asked me on February 4 what my thought was as the DIA broke through its high. In my response, I mentioned that I may start buying some DIA at the current price range. Here is a more concrete answer to how I am going to do this. On principle, on a rising market, I would try to buy on the dip or correction. In the following I am going to describe in detail how I go about doing this.

At the start of February, I was all cash then. With my trading program, every time when the market moves above my trading range, my portfolio becomes all cash. How do I reenter the market?

The market is full of ups and downs. Even when it is on the way up, it sometimes does so in tango steps, two steps up and one step down. I like to take advantage of such movements at the same time I try to minimize risks associated with buying in a rising market. The major drawback in buying in a rising market is that the market may turn downward soon after I make the purchase and I am left with stocks I have bought at high prices and that result in a paper loss. When the market goes into a severe correction, this paper loss can be significant.

Therefore, in a rising market I try to limit my exposure by committing only a small portion of my cash to buy stocks. I also try to trade in this period according to a prearranged program as mechanically as possible and with the least emotional input. Here is my methodology. It involves some mathematics, but bear with me for a while as I go through it.

My trading program comprises of the following parameters (the numbers quoted are of August 3, 2011, when I started the program):

  1. Trading top, $118
  2. Trading bottom: $66
  3. Trading step or interval: $2
  4. Lot size: 100 shares

The above four parameters determine the maximum No. of lot I would have purchased when DIA drops all the way down to $66 and the formula is:

No. of lot = 1 + (Top - Bottom)/step = 27

They also determine the average price of DIA purchased when DIA drops all the way down to $66 and the formula is:

Average price = (Bottom + Top)/2 = $92

The last two formulas then determine the total reserve I would need to weather a market downturn all the way to DIA = $66 and the formula is:

Total reserve = Average price x No. of lot x lot size = $248,400

So, on August 3, 2011, I got started by putting aside $248,400 for this program. The market has since gone through a significant down and up and it is now at a level somewhat above where I started. The nature of this program is such that when the market goes above the trading range set by the program, the portfolio goes into all cash. So, I was back to all cash after I sold off the last of DIA at $124 I held under this program in January 3 of this year. With that my cash position had risen to $260,099.60, a 4% increase over the initial total reserve. Since then, I have been looking for a point of reentry into the market. Here, I use the same formulae described above to determine the reentry point but with some changes in the parameters.

The first change is the total reserve. The total reserve is $260,099.60 which I had in my portfolio when I became all cash, instead of $248,400.00 before.

The second change is the top of my trading range. It moves up with the market and it is the highest price reached after I have gone into all cash. On February 9th, DIA reached a high of $129.12.

The third change is the size of the step. With the two changes above, I cannot set the step size freely. The formulae mentioned above would set the step size automatically. Here is how.

If you have some algebra background, you may solve the formulae above for the Step size arriving at the result below:

Step = (Top **2 - Bottom **2)/ {[2 x Total Reserve / Lot Size] - Bottom - Top}

Please note that, in the above, a double star ** denotes "to the power of."

[By the way, you may solve the same formulae for other parameters, like:

Top = {[2 x Step x Total Reserve / Lot Size] + [Bottom - (Step / 2)]**2}**0.5 - (Step/2)

Bottom = {[Top + (Step/2)] **2 - [2 x Step x Total Reserve / Lot Size] }**0.5 + (Step/2)

These results are useful in looking at other possible combinations of the trading program.]

As the market moving up, I apply the current price of DIA as the Top and the equation for Step above gives me the value of Step which is the "dip" or "correction" I need to reenter the market.

On February 9th, DIA reached a high of $129.12 and I have the following set of numbers:

Total reserve = $260,099.60

Top = $129.12

Bottom = $66.00

Lot size = 100

I then got the following Step size from the formula above:

Step = $2.40

This result tells me my reentry point is $2.40 below $129.12 and that if I start buying 100 shares of DIA at $129.12 and then 100 shares each thereafter with each drop of $2.40 in the price of DIA, my fund will last till DIA reaches a bottom of $66. However, for simplicity sake, I use the following parameters for my reentry point:

Step = $2.50

Lot size = 100

First buy = $127.50

Here, the first buy price of $127.50 is set at $2.50 below $130.00 (a rounded off number of the recent high of $129.12). With this, I am set to start buying 100 shares of DIA at $127.50 and then 100 shares each for every $2.50 drop in its price. Also, from here on, I would sell off each lot of DIA at $2.50 above its purchasing price.

The next day, February 10th, the day after reaching the recent high, the market retreated and DIA went down to as low as $127.30 and I made my purchase of 100 shares of DIA.

What I am doing here is essentially this: In a rising market, whenever my portfolio goes into all cash, I simply expand my trading range up to the most recent market high. I then determine the step size under the new set of parameters and set my reentry point to be one step size below the most recent market high.

With this, I accomplish the following:

  • I can participate in the rising market
  • Avoid buying at the top of the market
  • Keep my exposure to the high end of the market at a minimum

The last point is very important. In a rising market, we weigh two contradicting possibilities. One is missing the market gain by not participating aggressively. Another is that, after participating in the rising market aggressively, only to see the market turn south. Personally, I go for a timid participation. I can afford to be timid because I am not managing a fund for other people. I don't have to compare my investment result with, say, DJIA or S&P 500 (NYSEARCA:SPY).

The most important thing for me is capital preservation and to see my portfolio gain through minimum of risks. Any time in making a trade decision, I don't want to feel under pressure to take too much risk. When the market tanks and DIA goes all the way down to $66, sure I would be under a tremendous pressure to make that purchase at $66. However, what weighs most in my mind at that time would be how the U. S. economy as a whole may weather that kind of severe downward movement. I would make that purchase if I have faith in the U. S. economy at that time.

Disclosure: I am long DIA.