Cramer's 'Mad Money' Recap: Playing a Short-Term Rally

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(This program last aired Aug. 31, 2012.)

NEW YORK ( TheStreet) -- There's nothing worse than watching the averages soar while your portfolio barely moves, Jim Cramer told "Mad Money" viewers Friday. He dedicated the show to the rules for taking advantage of a short-term market rally.

Cramer said that knowing how to approach a rally will definitely make you a better investor because, while it may seem like your portfolio can run itself during a rally, in fact, rallies are the perfect opportunity to lighten up on your positions and take profits.

"You don't have a profit until you sell something," Cramer reminded viewers, which is why he always encourages investors to sell into strength, then use market weakness as an opportunity to buy back in at a lower price. Hang on too long, cautioned Cramer, and risk watching your profits evaporate before your eyes.

The key to approaching any rally, said Cramer, is to look at it with some pessimism, something that shouldn't be hard after years of being held hostage by the financial woes of Europe. Never let "rally euphoria" lead to complacency, he said, because profits can disappear just as fast as they appear.

Don't Panic!

People always want help when the market sells off, Cramer told viewers. While it's normal to panic in the face of losses, Cramer said investors need to reject he notion that people only need help when the market is lousy. Mistakes happen on the way up as well.

Cramer said his first rule for rallies is to be tough on your portfolio during big "up" days. The only time to scrutinize more is in the middle of a big decline with seemingly no end in sight. "Assume everything is guilty until proven innocent," said Cramer, and make each of your holdings prove why it's worth holding.

It's only natural to develop a love affair with stocks that are making you money. After all, they've made you wealthier so of course you're going to want more. But in reality you should like your winners less, said Cramer. For one thing, they've just gotten more expensive and therefore less attractive. When the downside outweighs the upside it's "end of story," said Cramer.

To help sort out the holdings in your portfolio, Cramer said he likes to rate each stock on a scale from one to four. Ones are stocks he'd buy at the current price while twos are stocks he'd buy on a pullback. Threes are stocks to sell at a higher price and fours are stocks to sell now.

Cramer said using a simple rating system allows investors to remove emotions from the rally equation. As the market moves higher, stocks that were a one become a two, stocks that were a three become a four. If the fundamentals haven't changed, Cramer concluded, that stock you're in love with may have just gotten too expensive.

King Cash

"Cash is king," was Cramer's third lesson for investors. He reminded them that cash is what makes everything else possible, and a portfolio without cash on hand is like a car running on empty.

Cash provides flexibility, said Cramer, so when the market gives you an opportunity to start a position you can take it. Likewise, if there's an opportunity to add to a position, you can do that as well. You need to have some cash on the sidelines or you won't be able to do any buying without first selling something else.

How much cash should an investor keep on hand? Cramer said 5% of a portfolio is a good minimum, but he's gone as high as 20% at times when market euphoria seemed to be too high.

Be Prepared

Next, Cramer said that in order to take maximum advantage of a big market run, investors need to be prepared to sell, sell, sell.

Generally, people don't like to talk about selling, said Cramer, but it's part of the investing process since the goal really is to "buy low and sell high."

Good companies have get very expensive, as investors have seen with high-fliers like Chipotle Mexican Grill ( CMG), Netflix ( NFLX) and Deckers Outdoor ( DECK) and, in the era before that, Intel ( INTC), Cisco ( CSCO) and Microsoft ( MSFT).

A big "up" day or two gives investors the perfect opportunity to sell, which in turn protects them from potential downside. That doesn't mean you should sell everything, however -- you're looking to balance capital preservation with capital appreciation.

The quality of the stocks is not in question, Cramer concluded, only the price.

A Portfolio Red Flag

What can a major move higher in the markets tell you about your portfolio? A lot, said Cramer. He said underperforming the markets during a big move is not that big a deal, but if your portfolio radically outperforms the market, that's a major red flag.

Cramer explained that when your portfolio leaves the major averages in the dust, it usually means you're taking on too much risk. "Taking on unnecessary risk makes no sense," he said, and watching how your portfolio performs during a rally will tell you just how much risk you're taking. Stocks that have big "up" days also have big "down" days.

Performing too well during a rally can also mean your portfolio is not properly diversified, said Cramer. Not having proper diversification can wipe out an entire portfolio in a heartbeat -- just ask those with tech portfolios in 2000 and 2001. No more than 20% of your portfolio should ever be in a single sector, he reminded viewers.

Curb Your Emotions

Cramer's final rule for market rallies: Don't chase stocks higher. He said after a big one-day move in the markets, it's very tempting to want to step up and buy more the following day.

"Don't do it," Cramer advised. Don't let your emotions lead you astray because you simply cannot buy stocks after the market has just spiked. It may sound crazy, he said, but there will always be a pullback coming, one that will afford you a better entry price.

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

To email Scott about this article, click here: Scott Rutt

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At the time of publication, Cramer's Action Alerts PLUS had no position in stocks mentioned.

Jim Cramer, host of the CNBC television program "Mad Money," is a Markets Commentator for TheStreet.com, Inc., and CNBC, and a director and co-founder of TheStreet.com. All opinions expressed by Mr. Cramer on "Mad Money" are his own and do not reflect the opinions of TheStreet.com or its affiliates, or CNBC, NBC Universal or their parent company or affiliates. Mr. Cramer's opinions are based upon information he considers to be reliable, but neither TheStreet.com, nor CNBC, nor either of their affiliates and/or subsidiaries warrant its completeness or accuracy, and it should not be relied upon as such. Mr. Cramer's statements are based on his opinions at the time statements are made, and are subject to change without notice. No part of Mr. Cramer's compensation from CNBC or TheStreet.com is related to the specific opinions expressed by him on "Mad Money."

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