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Dennis Gartman, famed author of the Gartman newsletter, claims that the worst mistake an investor can make is averaging down on a stock. He tells his readers that when a stock moves higher, that's the time to average in or average up. In January 2008, Gartman told the audience at the Toronto Financial Forum that America had entered a recession, probably in late 2007. In early 2008 he was short stocks like Google and RIM and was long Gold, Agriculture Commodities and Bank Stocks. Gartman has mentioned a number of times that top traders, such as himself, will be wrong 60 to 80 percent of the time or more. He believes that it is important to sell quickly when it is apparent a trade is not working out. He believes that when a trade does work out, the investor should buy more as the stock is moving in the right direction.

This is also the basis of Vector Vest. Dr. Bard DiLiddo uses a momentum approach to tells investors when to buy stocks. His momentum indicators then tell him when to sell those stocks as momentum turns.

So what is the best approach to take?

In a bull market the opportunity for gains on most stocks is much greater. There is some truth to the saying "a rising tide lifts all" stocks. In a bear market, devastating losses can result as panic selling can drop stock values by 50, 60 or even 90 percent or more as we saw in fall 2008 and again in March 2009. Companies like AIG fell from $493.00 to around $6.00. In Canada stocks like Manulife (MFC) fell from $40.00 to $9.02. Literally trillions of dollars have been wiped out.

The problem for most investors is not knowing when to sell their "winning" stocks. Therefore when a stock turns down most hold on hoping for a recovery and then they convince themselves they will "sell to get out". I believe there is a better way, depending on the stock selected, to recover quicker, move back to a profit position and then decide whether to "get out" and seek a different stock. To do this I have learned to combine options - namely covered calls and naked puts to assist me in averaging down in a losing stock in order to generate a positive return. But for this type of averaging down strategy to be successful I have developed 7 rules which I believe must be followed.

Here are my 7 rules I follow for when and how to average down in stocks:

1) The most important rule is stock selection. Stocks have to be large blue chip companies with strong dividends, solid balance sheets, low P/E ratios, good cash flow, low debt levels and reasonable payout ratios. This may seem like a tall order, but there are many of these stocks available.

2) Set reasonable guidelines as to the quantity of stock and dollar amounts you want to invest in any one stock. 15% of your total stock portfolio in one stock is probably more than enough for most people.

3) After setting your guidelines as to the amount of stock you wish to purchase, average into that quantity over time, to take advantage of pullbacks. If not a Canadian retirement account, average into stocks through selling naked puts.

4) Use the selling of puts to generate income while waiting for a decline in stocks. Consider laddering your naked puts if required in order to keep to the strike point you originally selected. For example if you wanted to be in a stock at 30.00 and the stock rises to 45.00, you may have to go out 6 to 12 months to continue selling naked puts at the 30.00 strike. Remember that stocks move around a lot more than analysts might have you believe. A sudden run-up in a stock can be followed by just as dramatic a downturn.

Pick a handful of blue chip stocks and paper trade them for a while. Plot each move up to a new high and see how often that new high is accompanied by a sell off. This is a common situation as traders accumulate stock and then when a new high is reached they sell on the new high. The following day or two the stock pulls back and these same traders load up again on the same stock. When another new high is set, they again sell their shares on the day of the new high. Yet another sell off ensues and once again these same traders buy the stock. This is a repeat pattern that is common on stocks. The stock is in a definite uptrend, but traders are making returns off each new high. Don't be the investor who buys on the new high. Wait a day or two and be among the traders who buy in the sell off. By paper trading a handful of quality blue chip stocks you will gain insight into the ways of the traders and learn when to buy and why you should never consider buying on a new high day.

5) If your stock declines dramatically, research the stock to determine if the fundamentals have not changed. If they have not, you could consider rolling down your covered calls and going further out in time. You can also consider placing a collar on your stock. (I will post another article on collars shortly). Try not to sell below your cost basis however which can lock you into a loss situation, but as you will see in my two examples, I have often sold below my cost basis to work my way out of a losing trade.

6) I believe in keeping 30% of my portfolio in cash instruments in case my stocks should decline or a new opportunity presents itself. If you examine my Royal Bank trade or my Sunlife trade, you can see that my returns hinged completely on being secure in the belief that I could average down and add to my position as the stock declined. If I had not been able to do this with confidence, then my return would have been greatly reduced. So while Sunlife and Royal Bank saw dramatic declines along with other financial stocks, the fundamentals of both companies remained solid, making the decision to average down, easy.