Investor's Corner: Don't Try To Outthink Follow-Through Day

• Paul Whitfield
• On 6:52 pm EST, Friday November 6, 2009

If you use the right tool in the wrong way, you'll probably be disappointed.

The follow-through day is a concept many investors understand. It means an uptrend is under way.

But an intellectual understanding is one thing. The discipline to act on it correctly is another.

A follow-through day involves a significant gain in a major index in greater volume than the day before. It occurs on Day 4 or later of an attempted rally.

An attempted rally begins when a major index makes a low, then closes with a gain. The rally attempt continues as long as the low of Day 1 isn't undercut.

Resist the impulse to act prematurely. Research shows that the early days can't tell you if the rally will succeed.

"Occasionally, but rarely, a follow-through occurs as early as the third day of the rally," IBD's chairman and founder, William J. O'Neil, wrote in "How to Make Money in Stocks."

"In such a case, the first, second, and third days must all be very powerful," he added.

Quite a few investors know this. But let's take a hypothetical look at how three different investors react to a follow-through day.

When a follow-through day occurs, Will B. Rash is ready to dive in with abandon. If three out of every four stocks go up in an uptrend, why hold back?

Mr. Rash takes full positions and believes that those who don't should "turn in their man card."

But this dash to full exposure suggests that Mr. Rash is missing a few cards himself: A follow-through day tells you the rally is likely to be real. It's no guarantee.

Indeed, while every market bottom has had a follow-through, not every follow-through results in a new uptrend. Sometimes they turn out to be false signals.

Mr. Rash risks losing a lot of money quickly.

I.M. Shaken is more likely to wait than act on a follow-through day. He stays 100% on the sidelines. Aren't the newspapers filled with gloomy headlines?

Mr. Shaken's gut feeling says it's far too risky to buy into this market.

But Mr. Shaken's attitude also points to a lack of understanding: The follow-through day isn't a mechanism for getting in touch with your feelings. It's there to get around emotions that can mislead.

While Mr. Shaken is waiting for his emotions to catch up with reality, a rally can deliver big gains.

On the follow-through day, U.R. Savvy takes prudent action.

After finding a fundamentally strong stock breaking out of a valid base, Ms. Savvy opens a half position. If the stock rises 2% to 2.5%, she brings the position up to 80%. If it rises another 2% to 2.5%, the full position is completed.

If the stock works, Ms. Savvy might find more stocks to buy as they break out. If those work, she will eventually discover, voila, she's fully invested.

The beauty of this approach is that the leading stocks guide you to greater or lesser exposure.

If a stock starts to fail after an initial buy, you stop buying. Often you sell. If it works, you buy more.

Of course, human nature being human nature, either Mr. Rash or Mr. Shaken is going to be in a position to tell Ms. Savvy that he knew the outcome all along.

One rushed in, one stayed out, and events proved one of them to be a real man of genius.

But Ms. Savvy knows it's folly.

Over many trades and situations, guessing will have a mixed record.

Buzz up!