Sunday, February 16, 2014

Taking windfall profits– having your trigger finger on the sell button.

When buying an investment you need to determine beforehand how to exit it. This will help you to develop a selling discipline that will protect you from excessive losses and thus improve your overall portfolio performance.

Exit strategies are:
       1.       Set a target sell price: e.g. 30% above the stock’s current intrinsic value

2.       Sell call options when the overall market becomes too hot (euphoric stage of a bull market) – this forces you to sell while cashing in option premiums (see earlier posts)

3.       Use option collars (combine strategy 2 with buying put options using  the proceeds of the sold call options). This limits your upside and but protects your downside in peaking market bubbles (see earlier posts)

4.       Use stop losses

But what about selling to take a windfall profit?  This is the counter strategy of stop loss selling.
For a stock to become so expensive that it trades 30% above the prevailing intrinsic value may take years if not eternity. For a stock to rise 15 to 20% in a year is not uncommon. For a stock to rise 30% in a month is exceptional and should cause alarm bells to go off. What triggers such alarm bells? Simple, just like you set a trailing stop loss price you have to set a 'take-profits-alarm' price. Let me give you an example:

Source: GlobeinvestorGold

Last year I listened to a pod cast by a trusted investment advisory company (yes, I do listen to others – though not too often J). The advisory recommended to buy Sears below $45 dollars because its real estate holdings were worth much more than its debt and the advisory estimated a net asset value of over $70 per share combined with having a brilliant CEO (Eddie Lampert).  I bought in August  2013 for $43. 
The chart above showed you what happened next. Sears took off with a vengeance and within a couple of months it peaked around $65. This was a lot of profit in a very short time. I made close to 44% in under 3 months or 175% annualized. There was no clear reason for such an explosion in the stock price and thus the alarm bells went off. I watched the stock for a few more days and sold because the profit was just too good to let it slip. I used the ‘take-profit-alarm’ set at 30% above the purchase price ($43+30%= $56) which was triggered in less than a month. Starting at $56 I checked on the stock at least twice-per-day and let it run until the first sign of trouble. The stock price kept on jumping higher and higher and then around $65 I knew this price was too good to be true and sold. Right after I sold the stock it went even higher; all the way to $70 and I regretted briefly my sale. Then in December the stock crashed first to $42 and then all the way down to $30.
One other thing, when I bought my position in August following the recommendation of the advisory service, I just bought a small position – 100 shares – enough to motivate me to monitor the stock and to hopefully build a larger position if the advisory’s recommendation worked out. With the violent uptick in price, I knew something was not normal – I did not risk any further money because I didn’t understand why the stock moved up so fast and I just let the stock ride. It was a thrill ride with only little money (proportionally to the overall portfolio) at risk. I didn’t buy more because I didn’t really know why the stock took off. I hope that you will also stumble across a little windfall like my Sears experience and that you will not get dragged along by emotion and let greed tempt you to buy more. It is fine to put a little bit of money at risk and let it ride. But if there is no obvious reason for a dramatic price increase in a stock you own then have your trigger finger on the sell button.

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