“Profit taking” is a general term used to describe selling a financial asset (in this case we’ll use a stock, but it could be a bond, mutual fund, currency, etc.) in order to lock in gains for a stock that has appreciated in value. There are many strategies in profit taking with respect to selling a complete position, time frames, overall portfolio positions and catalysts driving the rise, amongst others. Irrespective of details, we are believers in two fundamental cornerstones of trading: plan the trade and don’t be afraid to lock in profits.
Let’s first look at some of the influences potentially moving a stock.
Many factors can drive stocks higher and it is important to recognize what the catalyst is to begin with. For instance, a stock may move upward simply because it is part of a market segment that has overwhelming bullish sentiment. Consider so-called “pot stocks,” which tend to broadly move together on positive regulatory developments, acquisition news for a major, an earnings report or some other catalyst. While this is just one example, many stocks move simply by being a part of a sector that is en vogue with traders. Don’t discount the simple power of momentum, but don’t expect it to last forever either.
It’s important to know what is driving the stock higher because it can provide some insight as to whether or not the rise is sustainable. In the penny stock world, stocks frequently go vertical with absolutely no rationale. This phenomenon is often accompanied by a sharp reversal in which all gains are wiped out in a matter of days or even hours, leaving the unprepared trader with losses.
If a stock is ascending slow and steady (a stock “uptrend”) and the gain is underscored by fundamental strengths of the company, such as earnings or a new partnership that bodes well for future profits, traders can be more patient.
The stock market is all about anticipation. Therefore, upcoming milestones can often send a stock higher. For example, biotechs can tend to gain ahead of a drug decision by the Food and Drug Administration. Four times a year, analysts and traders are locked in on companies posting results from the recent quarter. If people think the results are going to be good, the stock will rise into the earnings release.
While not all-inclusive by any stretch of the imagination, these examples provide some insight as to things to look for to discern what is underlying the gain for any stock. If it’s not a durable reason, profit taking is a must.
So when is it time to take profits?
This is the eternal question for which there is no absolute answer. Every trader has held a stock for too long and seen profits evaporate as the price comes back down. On the other side of the coin, any experienced trader has sold for a profit only to watch the stock continue to rise. As a trader becomes more seasoned, a balance is generally found without regret for whichever way the trade goes.
We are firm believers in setting a price target – whether it is 15%, 25%, 50% or what have you – and sticking to the game plan to dock profits. How you set that target can vary based upon fundamentals, technicals or a combination of the two (which we suggest).
Do not ignore technical analysis because it is a big component of the broad markets, especially with algorithms and computer-assisted trading nowadays. Often times, profit taking will happen at a stock chart’s point of technical resistance, so it is imperative to recognize these levels before entering a trade.
Most traders do not operate on the concept of completely selling a position in a company they believe in based upon due diligence. A prudent trade strategy is to sell a portion of the position, while keeping the rest for expected continuation to the stock’s rise. This mitigates, or completely removes, risk.
To lend some color, let’s say a trader has bought $1,000 worth of XYZ Corp. at $2.50 (400 shares). The stock climbs 50% to $3.75. A safe way to play this is to sell $1,000 worth of XYZ (~267 shares), leaving the trader with 133 shares while recouping all the investment. Effectively, the investor is now playing with about $500 of “house money.”
This strategy is particularly useful with volatile stocks, especially “over the counter” penny stocks.
Other traders will modify the percentages based upon price targets. Regardless, it still involves banking some gains and having a target when entering the trade and sticking to it. This mentality is underscored by trading mantras like “emotionless trading,” “Green is good” and “There is no such thing as a bad profit.”
We’ll leave you with one trading nugget about locking in profits, even if they are relatively small. It’s all about compounding gains. Starting with $500, if a trader can make 81 consecutive trades that return 10% (adding the gains from each trade to the next one), that $500 turns into $1 million. Slow and steady does really win the race with that strategy.
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