- Investors often struggle to buy back stock after suffering losses.
- Smaller initial positions, or probing trades, can prudently help you get back into the market.
- Increasing probing trades via progressive exposure improves risk to reward.
One challenge facing investors during a bear market is answering the question, “when is it OK to buy?” Unfortunately, trying to answer that question can lead to analysis paralysis, making you miss out on significant returns in the early stage of the next bull market advance.
Instead of thinking of stocks in “all or nothing” terms, adopting a piecemeal approach may be the best strategy. Making smaller initial investments to probe the market can allow you to benefit from an improving market with less risk, especially when used alongside progressive exposure, increasing your position only if your initial buy works.
This investment strategy has been a hallmark of many successful investors, including the famous speculator Jesse Livermore and, recently, Mark Minervini, a trader featured in Jack Schwager’s great Market Wizards book series.
Go small, not big
“The biggest losses that most investors suffer are when they 'buy low' in a bear market. When the stock goes even lower, the frustration and pain become too much, so they capitulate and lock in a big loss. There are two problems with the "buy low"' approach. First, we have no idea if the current low is the low. In bear markets, support is meaningless, and it can be shocking how far a 'good' stock may fall before it eventually hits bottom. The second issue is our emotions. Our plans go out the window if our entry point is poor and we start racking up losses. As Mike Tyson once said, "Everyone has a plan until they get punched in the face."
In bear markets, most stocks fail to hold key support levels. As a result, bull market tactics, such as buying dips to critical support levels, such as the 200-day moving average or horizontal lines connecting previous lows, don’t work. Unfortunately, bear markets are hard to identify early on, so many investors wind up stuck in losing positions, causing cascading losses and, eventually, a “no mas, get me out” moment when they sell, often near the market’s low.
Freshly feeling the sting of those losses, their mindset shifts from greediness (buying every dip) to fearfulness (sitting on the sidelines or selling every rally). That shift can limit drawdown in the first half of a bear market. However, it can be costly in the second half because bear markets are shorter in duration than bull markets, and returns in the first year of a new bull market are best. For example, the S&P 500 historically gains 38% in year one of a bull market but only 12% in year two, according to Sam Stovall of CFRA Research.
Back to DePorre:
“How do we deal with the problem of poor timing and counterproductive emotions in a bear market? One solution is "probing buys"...a strategy that Jesse Livermore developed. particularly frustrating for Livermore was that many of his major losing trades would have worked extremely well if his timing had been just a little different. He built his position too big and fast and couldn't stay with them when they didn't immediately work…Livermore dealt with this timing problem by developing a method called "probing".
Rather than jump right in immediately, he would probe the market by making small buys that would help him gain a sense of the price action. If he liked what he saw, he would add to the position and start to pyramid it as it moved in his favor. Livermore compared his approach to a military officer sending a patrol to spy on the enemy and gather intelligence. The knowledge gained by this probing would allow him to attack aggressively at the right time.”
Livermore short-circuited the risk of analysis paralysis by embracing a "buy small" approach that allowed him to profit if he was right and limit the risk if he was wrong.
How to use probing trades and progressive exposure
Livermore’s dip-your-toes style strategy helps investors limit losses, but how much capital should investors be willing to risk on probing trades? DePorre writes:
“Livermore had two key conditions for his probing buys. First, he determined the size he ultimately intended to hold should the stock develop in the manner he liked. He had a plan in advance and didn't just add shares randomly. His initial probing buy would generally be about 20% of the total size he had planned.”
So, suppose your goal is to have a $100,000 portfolio of 20 stocks, which works out to $5000 per position. In that scenario, you would initially invest 20%, or $1,000. Then, you’d look to increase exposure to reach your $5,000 target allocation opportunistically.
However, progressive exposure means you’d only buy more if you made money on the first buy. In fact, you’d contain your loss with a stop-loss order. For example, assuming a 10% stop loss, the most you’d lose on your initial $1,000 would be $100, representing just 0.10% of your capital. DePorre writes:
“You only add to the trade if it acts positively. You don't try to lower your cost basis because you hope the market will eventually appreciate the positive fundamentals of this stock. What you do is add to your position as the price action proves that the market is discovering the merits of the situation…In the worst bear market, most probing trades will not work initially, but the approach limits your risk and leaves you in a position to try again and again until things start to work.”
The Smart Play
Cautious skepticism is wise in a bear market because rallies often fail at resistance. This makes controlling capital at risk important. However, if you’re too careful, you can wind up missing opportunities at the low, short-changing your account balance.
Instead of viewing buying as an “all-in” proposition, small probing trades can give you the best of both worlds. They offer you exposure to stocks that can pay off handsomely if you’re right while limiting how much you’ll lose if you’re wrong. So, consider embracing this strategy and using progressive exposure to increase your position if it’s working.