Just because it stops raining or snowing doesn't mean motorists should drive at full speed. Road surfaces can still be treacherous, so it's smart to maintain a moderate speed. Before this turns into a driving class, let's apply this safety concept to the stock market. In this case, the storm represents a market correction, and the drivers are investors anxious to load up on stocks when the skies clear — or when a follow-through has occurred, there's been a follow-through rally confirmation.
The follow-through is the most reliable bottoming signal in the market, but do not take it as a license to become immediately fully invested in stocks. View the follow-through as a green light to step back into the market in careful, deliberate steps.
One reason for this cautious approach is that while follow-throughs have marked every significant market bottom, not all follow-throughs result in lasting rallies. The follow-throughs of Aug. 23, 2011 and June 15, 2012 went nowhere, and anyone buying stocks on those stillborn follow-throughs faced a market in which sellers remained pervasive.
So, next time you've spotted a follow-through or read about it in The Big Picture, plan on entering the market and raising your exposure a little at a time. Buy one or two stocks that break out, then see how they act. If you're making money, it's a signal to step a little more on the gas pedal.
You can also control your exposure to individual stocks by "pyramiding." That's when you buy half your target full position at the , then buy 30% of the position once the stock is up 2%-3% from the buy point. You make your last purchase — 20% of the position — when the stock is 4%-5% above the entry level.
This is how this scenario could have played itself out this year: MercadoLibre (MELI), the Latin American e-commerce firm, broke out of a at 90.64 on March 6, just one day after the market made a follow-through. (See a daily chart.) Let's assume you have a $50,000 portfolio and you're partitioning $10,000 of that into the stock.
A 100% commitment would mean buying 110 shares at 90.64 each. So, on the , you buy 55 shares, for nearly $5,000. Two days later, it rose nearly 3% above the entry, meaning you would have bought 33 shares at 93.06. The next session, MercadoLibre had climbed 5% above the buy point, leaving a final purchase of 22 shares at 95.17.