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I am a IT Professional with a bachelors degree in Computer Science. I am not some multimillionaire (although I hope to be one day) I am an average everyday working person who decided to step out on his own and I want to encourage others to do the same. My investment profile closely resembles... More
  • Utilize Trailing Stops (For Dividend Growth Investors) 9 comments
    Apr 8, 2013 1:20 PM | about stocks: HSY, JNJ, PEP, WM, WMT

    Introduction:

    If you have read any of my previous articles you are probably very aware that I am a dividend growth investor. Dividend growth investors have a long range outlook on many of the stocks that they purchase and hold. Even DGI investors can recognize overbought markets and should consider ways to profit from those types of markets even and use them to enhance our long term positions. To achieve this goal I have started to utilize trailing stops for certain holdings that have increased significantly in value. Trailing stops allow me to lock in profits in my long term positions with the ability to buy back in at lower cost basis levels after market corrections. I would like to discuss the specifics of how I utilize these trailing stops and hopefully influence other DGI investors to consider doing the same.

    Why:

    The goal of any dividend growth investor is to increase long term dividend income. If you can achieve that by selling a stock at a certain price and then buying the same stock back at a lower price, why would you not? Even though most dividend centric portfolios have a much lower beta than most portfolios, they are not immune to market swings and corrections, especially in the case of overbought markets. Some of the stocks held in these portfolios more often than not become overbought with broader market increases.

    When:

    I have four rules when utilizing trailing stops which I would like to talk a little about. I will then give a couple examples of current trailing stops that are active in my dividend portfolio; a portfolio that I have discussed in more detail in this previous article.

    1) Never place a trailing stop on a stock that has been held less than a year.

    This is especially important if you are in the lower two tax brackets. Long term capital gains rates allow you portfolio to make you a profit without adding to your tax basis for the year. If a stock is held for less than one year it will be taxed at your current income bracket level. If a stock is held for longer than one year they will be taxed at 0% for the 10% and 15% tax brackets and will be taxed at 15% for all income brackets above the 15% bracket.

    2) Never place a trailing stop on any stock that has not grown by at least 20%

    One of the benefits of owning dividend paying stocks is to watch the dividend payments compound over time. This is one of the reasons that dividend investors are less likely to sell underwater stocks than other investors. The compounded dividend payments help the stock grow faster than a non dividend paying stock. For this reason we don't want to place trailing stops on any stock that has made us any less than 20% of our original purchase price because the stocks upward momentum from compounding has not accumulated over our investment timeframe.

    3) Never place a trailing stop on any stock that does not have an average daily share volume of at least 1 million shares.

    This is one lesson that I had to learn the hard way that I feel everyone should be aware of. I placed trailing stops on a few stocks that had lower daily volume and were subject to more drastic swings stocks with larger daily volume. Smaller daily volume stocks are more easily manipulated by larger entities with large transactions and can force you out of a position before it has run its course and peeked. For this reason we only utilize trailing stops on stocks that have larger daily volume share averages.

    4) Never place a trailing stop close enough that the trade would execute on a normal days trading window.

    Standard market corrections are generally in the 5-10% window with larger corrections possible for severely overbought markets. For this reason I utilize a 5% trailing stop. This means that my sale of a stock will only execute once the stock falls 5% from its highest trading value. Example: I bought a stock at $50 it climbs to $60 at which point I place a trailing stop order out against that stock that would execute around the $57 mark. It continues to climb to $70 dollars a share meaning my new trigger price has increased with the increase in price of the stock and now sits around $66.50. This trailing stop cushions any pain I may feel from a significant market correction.

    My Trailing Stops:

    Based on my rules above I currently have placed trailing stops on 4 out of 20 stocks in my portfolio and I am getting close to opening one more. My minimum profit is based upon the current trigger prices which may increase as stock prices increase.

    StockSharesTrigger PriceCost BasisMinimum Profit
    The Hershey Company (HSY)22.5416$82.09$1,500$343.49
    Johnson & Johnson (JNJ)23.0427$78.59$1,500$303.98
    Wal-Mart Stores Inc. (WMT)23.8481$72.76$1,500$228.24
    Waste Management, Inc. (WM)46.8771$37.05$1,500$229.85

    I am currently up more than 18% on PepsiCo Inc (PEP) and I will place a trailing stop on that stock as well as soon at it hits the 20% mark in my portfolio. By utilizing trailing stops on the investments above I guarantee myself at least an average 18.4% profit above my original investment.

    Summary:

    Utilizing trailing stops can be a nice way for DGI investors to cushion downside profit loss while at the same time allowing their stocks to run as far as they possibly can before hitting the sell button. This also assures that you increase your cash position during periods in which the market is trending downward. If the market falls far enough you may even consider repurchasing the same investments due to over correction in stock prices. Please comment below and let me know what other trading tools you may use to cushion downside losses.

    Disclosure: I am long HSY, JNJ, PEP, WM, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

    Themes: income-investing-strategy Stocks: HSY, JNJ, PEP, WM, WMT
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Comments (9)
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  • All other things being equal (like dividend, payout ratio, EPS) a drop in share price of a DGI stock (especially of 5-10%) isn't a sell event, rather its a buy event.

     

    So why are you triggering sales right when you should be buying?
    8 Apr 2013, 06:28 PM Reply Like
  • Author’s reply » Anything larger than a 5% correction affords you the ooportunity to increase your position if you sell when the stock hits down 5% and say it only drops to 8% you can still buy back in with 3% more shares than you had when the sale triggered. you have to look at the beta of the stocks you are trading if the beta is only 0.7 than it would take a market move of more than 7% for you stock to move the 5% to trigger the sale DGI stocks have lower beta's and therefore don't move when the market falls. What these stops are designed specifically protect is profit. I can buy back in at any time I want but I will lock in my profit and reinvest in the same stock now at a higher cost basis and in turn invest that profit in a new stock this is a solid way to help you diversify your portfolio over time. especially when you have some DGI stocks that have run high really fast such as HSY has done to me.
    9 Apr 2013, 07:57 AM Reply Like
  • First, you must remember that correlation is not causation. Beta doesn't mean that a drop in the "market" causes a drop in the share price of a stock (or the other way either). My issue is why are you doing this automatically? And why do you assume that you will always then be afforded a better price to buy back in?

     

    If you think a certain stock has run too far, trim or sell it and put the money elsewhere, don't depend on certain automatic actions to do the right thing.
    9 Apr 2013, 09:20 AM Reply Like
  • Author’s reply » While I agree with your general premise the reason i use automatic actions to perform this is that I am not always able to stare at a computer screen all day and know when to perform an action myself. also while I think a stock may have run to far too fast that doesn't mean it won't run further no one can predict tops and no one can predict bottoms so I will let it run as far as it wants to and be happy with profits of maximum share price -5%
    9 Apr 2013, 10:17 AM Reply Like
  • Don't WMT and WM violate rule #2 as you are locking profits of less than 20% with your stops?
    9 Apr 2013, 10:12 AM Reply Like
  • Author’s reply » very keen eye the profits are less than 20% but the 5% trailing stops are put in place once the stock reachs 20% so you are really locking in whatever your maximum share price was -5%
    9 Apr 2013, 10:15 AM Reply Like
  • Author’s reply » also on a side note something that I did not make mention of in the article. This practice allows me to rebalance my portfolio over time. a concept that I think a lot of DGI investors have either forgotten or neglect to do.
    9 Apr 2013, 10:25 AM Reply Like
  • "Example: I bought a stock at $50 it climbs to $60 at which point I place a trailing stop order out against that stock that would execute around the $57 mark."

     

    On your initial purchase of a stock why would you wait for an increase in share price to implement a trailing stop? Why not set a trailing stop from the onset in order to protect your capital?
    13 Jul 2013, 03:56 AM Reply Like
  • Author’s reply » Because in this day and age you could be quickly taken out of your position with a sudden fall in share price and a quick rise back to the same price which would put you back at the same starting position now with less money. If you buy a stock at $50 because you like the valeu and put a trailing stop of 5% if the stock takes a sudden turn downward of 6% than technically your value of The stock has increased as far as fair value is concerned but your trailing stop has just locked you into a lost position. Trailing stops have the potential to significantly harm your portfolio value by locking you I to losing positions that's why I feel that trailing stops should only be used on stocks where you have already made a profit. Trailing stops should be used for the protection of unrealized gains not for the preservation of capital. Preservation of capital is a much more complex concept that cannot factor all relevant parameters to determine which action to take. That decision should always remain the hands of the investor and not some rule.
    14 Jul 2013, 11:53 AM Reply Like
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