Best of Dragonfly Capital: 5 Methods of Protecting Profits

While I am on vacation I have combed through the archives to find the best articles that also stand the test of time. Here is today’s selection from March 2011:

Common wisdom says that as stocks you hold rise, you should protect your profits. That can mean different things to different people. You can also interpret it differently based on your view of what that stock has done and what it might have left in the tank. So just how do you act on this commonly held belief?

1. Scale Out. Many subscribe to this theory, but it has some drawbacks. If you sell a third or a quarter of your position into strength then you still have a large upside exposure, but not as much as before. And if the stock were to keep running as you are scaling out then you may only get a small piece of the run higher.

2. Raise Your Stops. Raising your stop is somewhat different in that you are not actually taking any profits, but protecting paper profits. You can either use a stop loss order or a stop limit order. The stop loss will become a market order once the stock hits your trigger. Often this leads to a stop out very near or at the stop loss level but in a thinly traded or gapping stock you could sell well below where you had intended. Using a stop limit, where when the trigger is hit it converts to a limit order, protects against that downside gap after your trigger is hit, but only if the stock recovers back above the limit price. Using these orders continues to allow full upside participation but at a price.

3. Trailing Stop. Using a trailing stop gives you a buffer against closing a winning position on a slight pullback. The buffer can either be a percentage of the stock value or a fixed amount, say 50 cents below the last price. This type of stop works best in a trending stock with little volatility. If the stock is very volatile then the trail amount would have to be very large to protect against a shake out and another method is preferable.

4. Stock Replacement. By selling your stock and then buying call options in a stock replacement strategy you do book some profits but also continue to participate in the upside of the stock. For this strategy it is a balancing act between choosing an option with a high enough delta to continue to gain as the stock does and not leaving too much premium in the option at risk. For stocks that move higher quickly this is my favorite method as I can often use some profits to by the call options and still put some profits in the bank.

5. Buy Puts. This method works best when your stock has moved above a critical level that needs protecting, when you believe there is still much more upside. In today’s market where the cost of puts is still relatively cheap it can look attractive.

Of course you can and should employ a combination of these tools. And no one tool is right or wrong for everyone or any stock. The key is to have a plan for what you are going to do based on your view of the critical price points for each stock that you are trading, before you put the position on, and then just execute the plan

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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