Selloffs Happen

The nature of trading dictates that, after a stock screams up ahead of good news, it's destined to pull back a bit afterwards.
Author:
Publish date:

Greed can be the enemy of clear thinking. This afternoon I got a frantic email from someone who was worried about a big drop in

Exodus

(EXDS)

.

I am not in the business of reassuring anyone, or

holding anybody's hand. But I am willing to interject some common sense when it is called for. In this case Exodus was up huge until Thursday of last week. It ramped all the way to 148. It is perfectly normal for all but the most ballistic of stocks to have a pullback of the kind this stock is having.

The interchange, however, caused me to take a moment and go over how the market works, particularly for you newer, and in some cases, more spoiled readers. The most important concern when I look at a stock is not what it is selling for or what it might do, but

where it has come from

.

(This point is something that chartists and I agree on, because I am always looking for proper entry points.)

I think the Exoduster who emailed me was greedy in

not

taking something off the table when it was higher. Here is a case where 30 points were left on the table. Neither commissions nor the taxman can hurt you as bad as the 30 points that were missed.

If a stock has had a giant run ahead of good news, you can expect that people will take profits on that good news. That's what trading discipline dictates. Let me give you an example. Let's say Jeff and I decide we want to buy

IBM

(IBM) - Get Report

because we think it is going to have a good quarter. After it reports, we are going to sell it because we bought it for the quarter only.

(If we viewed it as an investment, things would be different. We decide in advance of buying something, however, whether it is a trade or an investment, even going so far as to list stocks as T's on our sheets so we don't turn a T into an investment.)

Had IBM run up huge in advance of that quarter, we might have even been tempted to take profits ahead of the quarter, for fear that whatever good news is out there is "already in" the stock. The chart is what tells you whether good news is already in.

Unfortunately, there is no simple science to analyze this stuff, even though we all desire a formula to make things magically easy. We can't say, if IBM is up 10 points in the last three days, we can therefore expect it to go down five if it reports 88 cents, and up five if it reports $1.02. It is all psychology.

Our experience in these situations is that we should expect stocks to sell off unless they exceed even the biggest bull's judgment

if the stock has run

. If the stock hasn't run (e.g.

Intel

(INTC) - Get Report

, which was still where it was at the beginning of the year despite the market being up 20%), it has a better chance of moving up regardless of the quarter.

And if it is down big ahead of the quarter, then we could say that the risk is taken out of the stock and we might even expect a pop on bad news.

So, before you jump to a conclusion about a stock's action based on a given quarter, ask yourself whether the stock, by its trajectory, has priced in a move. And be forgiving of a stock for pulling in big-time after a giant push upward. But don't be forgiving of yourself if you bought it for a trade ahead of that colossal move and didn't take anything off the table when you had a chance.

James J. Cramer is manager of a hedge fund and co-founder of TheStreet.com. At time of publication, his fund was long IBM and Intel. His fund often buys and sells securities that are the subject of his columns, both before and after the columns are published, and the positions that his fund takes may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

jjcletters@thestreet.com.