CMU: When to take profits

Cracked.Market University:

The only way to make money in the stock market is by taking profits in our favorite trades. This blog post covers how I lock-in profits. This is a particularly timely post, not because I think this is the time to take profits, but because of what taking profits allows me to do.

First, I don’t know how to consistently pick tops and I bet most of you don’t either. If we cannot pick the top, then by rule, we are either selling too early or we are selling too late. Both strategies are perfectly acceptable and they come with their own unique set of advantages and disadvantages.

The first and easiest to understand is selling too late. This happens when we hold a stock past the peak and sell it on the way down. We’re in this to make money and that means we naturally want to squeeze every last dime of profit out of a trade. Who wants to sell for a 10% profit only to watch the stock rally another 200%?

The most conventional way of selling late is following the stock higher with a trailing stop. When the stock rallies from $50 to $60, we move our $40 stop up to $50. If the stock moves up to $70, we lift our stop to $60. We repeat this process until the stock finally peaks and dips under our trailing stop. This seems easy enough.

(Of course, a lot of traders are not sensible and rather than employ a thoughtful system like a trailing stop, they react impulsively to every bump in the road and only sell after they become convinced their favorite stock is crashing. And as most of us know from personal experience, this happens moments before prices rebound!)

But there is another way to take profits and is the approach I prefer, selling winners on the way up. The most obvious disadvantage of selling early is once we get out, we give up on any further upside. Unfortunately, most people believe this and it is absolutely not true. Just because we sold last week, yesterday, or even this morning doesn’t mean we cannot jump back in if the conditions warrant it. But most people have the mindset that once they sell, they are out of the trade and this just isn’t true. Selling simply means the risk/reward is no longer stacked in our favor. But like everything in the market, the situation can change quickly.

There are two reasons I like selling early. First, taking profits early frees my mind to look for the next trading opportunity. Selling early leaves me hungry and forces me to start looking for something to do with my cash. Sometimes that means buying back in after a short period out of the market. Other times it allows me to be the hungry dip buyer during the next dip. Second, I don’t like holding stocks moving sideways. I’m not getting paid when a stock is consolidating, yet when I own a stock, I continue holding all of the risks of the unknown. I only want to hold risk when I’m getting paid and that means avoiding stocks moving sideways.

The reason this applies to our current market is because I took profits proactively before the holidays. The S&P 500 rallied above 3,200 in mid-December and that was good enough for me. Every other time the market hit a round level over the last few months, it traded sideways for a bit. Now, I will freely admit I missed the move a few days later to 3,250, but I wasn’t worried about it. Not long after later prices tumbled and when the crowd was fearfully debating whether they should bailout before the market crashes, I was eagerly looking at this dip as a buying opportunity. While people were abandoning ship yesterday, I was buying the dip.

Selling early gives me more flexibility and it keeps me out of the market when I don’t need to be in. I had a nice holiday out of the market and taking profits early left me in a great position to jump back in once the market presented the next opportunity.

That said, this is what works for me and it doesn’t necessarily apply to you. Find the strategy that works for you and stick to it. The only way to do this wrong is making it an emotional decision.

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