Cramer's 'Mad Money' Recap: Rally Rules

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NEW YORK ( TheStreet) -- "Knowing how to approach a rally the right way can definitely make you a better investor," Jim Cramer told the viewers of his "Mad Money" TV show Wednesday as he opened up his playbook to help home gamers score big during short-term rallies.

Cramer said that everyone makes money in a big rally, but it's the smaller rallies that can separate good investors from great ones. He said that nobody wants to miss a rally, but that's what typically happens when individual investors get caught off guard.

Investors have to approach every rally with a grain of pessimism about what's coming next, said Cramer, but it's wrong to approach rallies with too much pessimism. "There's nothing wrong with feeling good about a rally."

What really hurts individual investors is complacency, Cramer told viewers, whether it's the euphoria that a rally can last forever, or the pessimism that things are bad, and will stay bad, forever. He said that it may be hard to be counter-intuitive, but he always advises selling into strength and buying into weakness.

"The name of the game is preparation," said Cramer. Prepare yourself for a rally by owning stocks, and prepare for the bad days by lightening your positions. "Don't get carried away," Cramer concluded, "keep your head on straight and focus on the long term."

Harsh Checkup

"Be really tough on your portfolio on big up days," was Cramer's first rule for investors. He said there's only one time when you should be harder on your portfolio, and that's in the middle of a brutal decline when you're forced to "circle the wagons" and protect your nest egg.

How does one get tough on their portfolio? Cramer said by giving each stock in your portfolio a harsh evaluation. "Assume everything is guilty under proven innocent," he advised. Emphasize the downside risks, and make every stock prove its worth holding onto.

Just because your stocks went up today doesn't mean they're headed the same direction tomorrow, Cramer told viewers. And in fact, as stock prices increase, the risk reward equation changes, making a thorough re-evaluation crucial. For example, if you owned a stock that you thought could go up $9 or down $3, and it goes up $4, then the upside becomes $5 and the downside $7, meaning what was once a 3:1 risk reward has now turned south.

Cramer said the second reason to re-evaluate is to know when to sell. "A rally is a selling opportunity," he explained, but if you don't know when to sell, you'll never be ready to take advantage of the big up days.

Cramer advised ranking all of your stocks using a simple scale from one to four, one's being stocks you'd own at any price, two's being stocks you'd buy on a pullback, three's being stocks you'd sell at a higher price, and four's being stocks that need to be sold now.

Selling Strategy

Cramer's next rule for investors: have a plan for selling every stock, even before you buy it. People may not like to hear about selling stocks, but Cramer said the name of the game is preparation, and market rallies are the best time to sell.

Cramer said playing the stock market is a balancing act, trying to balance capital appreciation with capital preservation. Keeping your money safe, he said, is just as important as growing it.

"Cash, my friends, is what makes everything possible," he noted. According to Cramer, cash provides flexibility, which is why he always advises having between 5% and 10% of one's portfolio in cash so you can start a new position, or double down on a good position.

That's precisely why Cramer recommends selling into a rally, as the best time to have a lot of cash is right after a rally, when the market retreats and stocks become cheaper. Cramer said it may seem like a common sense approach, but too many investors fail to recognize it.

Cramer said his two cardinal rules for market rallies: raise cash and do not buy.

So which stocks should investors sell into a rally? Cramer said there are two types: good stocks that have had a great run and bad stocks that are just embarrassing.

Why sell good stocks? Cramer reminded viewers of Rule No. 10 in his book Getting Back To Even: Don't dig in your heels. He said too many times he gets hate mail from viewers who are upset that he's changed his mind on a hot stock, and advises selling before a rally is over. But Cramer said the truth is there is a price to buy and a price to sell, and he never advises being greedy.

Cramer said he'd use a rally to trim back positions in his really big winners, especially in any momentum stocks that have really been on a roll. He said these stocks, by their nature, will begin to take over a larger and larger percentage of your portfolio, which makes them riskier as time goes on.

Also on the chopping block are the losers in your portfolio. Cramer said if you own a stock that does nothing during a big rally, it's probably a dud and isn't worth your investment. He said not all laggards are losers, but poor performance in a strong rally is a great way to identify potential losers. "We don't care about blame," said Cramer, "we care about winning."

Cramer said his bottom line for after a big rally: sell some of the big winners, sell the momentum stocks and sell the losers you were probably planning on selling anyway.

A rally can teach you a lot about your portfolio, Cramer told viewers. He said if your stocks are dramatically outperforming the averages, that's reason for concern.

Cramer said it is possible to make too much money in the markets. He said if your stocks are pouncing the markets, then it simply means one thing: You're taking on too much risk. Crushing the averages in a rally, he said, can get you crushed in a sell-off.

One way to prevent such a crushing is to stay diversified, Cramer said, which is why he preaches diversification every week on "Mad Money." "Keeping all your eggs in one stock basket can wipe you out in a heartbeat," he reminded investors.

-- Written by Scott Rutt in Washington D.C.

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