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Utilize Trailing Stops (For Dividend Growth Investors)

|Includes:The Hershey Company (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.

Stock Shares Trigger Price Cost Basis Minimum Profit
The Hershey Company (NYSE:HSY) 22.5416 $82.09 $1,500 $343.49
Johnson & Johnson (NYSE:JNJ) 23.0427 $78.59 $1,500 $303.98
Wal-Mart Stores Inc. (NYSE:WMT) 23.8481 $72.76 $1,500 $228.24
Waste Management, Inc. (NYSE:WM) 46.8771 $37.05 $1,500 $229.85

I am currently up more than 18% on PepsiCo Inc (NYSE: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.

Stocks: HSY, JNJ, PEP, WM, WMT