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Dan Calugar on Understanding the Stock Market: Profit-Taking

Novice investors can be shaken by a sudden drop in the price of a stock they hold. Understanding profit-taking and why it happens can help allay fears that might lead to panic selling. In this article, Dan Calugar, an experienced investor, offers a simple explanation.

There are two key things to remember when thinking about profit-taking. One is that profit-taking is the intended result of every investment. Until profits are taken, there is only potential value in a stock, not real value. The second thing to remember is that profit-taking says more about the individual trader and their strategy and circumstances than it does about the company being traded. 

A novice trader may forget either or both of these facts and be unnecessarily unnerved when a stock they hold experiences a decline due to profit-taking by other investors. Novice traders get rattled by profit-taking more than experienced traders that have developed and perfected their own exit strategies over time. 

Until a trader has put their exit strategy into practice, it can be challenging to envision why investors would sell off a perfectly performing stock unless they know of some impending disaster. But wise investors take profits, and they do it because the investment has met their predefined exit strategy.

There are as many profit-taking exit strategies as there are investors, but many work something like this: 

The investor buys a stock with the intent of taking profit from the investment once they reach a sell price of twice what they have risked. This simple profit-taking strategy is popular because you will make money even if you’re wrong half of the time.

With the variations of this strategy, some investors will only sell off half of their investment—or take half the profit, ensuring that they have recouped their initial investment. There are other strategies, but the point is that the profit-taking takes place not because the long-term expectation has changed, rather the stock has reached a predetermined price threshold and needs to be sold to fit the exit strategy. 

Profit-taking can also be triggered by investors that have found an even more lucrative place to put their money. It is the individual circumstances of the investor that often dictates when a stock is sold. It is not always a reflection of the performance of the stock.

To be sure, however, profit-taking can be an indication that a company or even a market sector is in trouble. When this is the case, there will typically be many dissimilar investors that come to the same conclusion at about the same time. It may be an earnings report or an unsettling development in the sector. For example, if too many tech giants report poor earnings, some investors will start looking at other sectors to avoid a potential global downturn. 

To avoid making an unwarranted panic sell of a good investment, it is crucial to understand the many reasons that profits can be taken. Developing and executing your exit strategy will drive that point home and help you on your way to becoming a seasoned investor. 

About Daniel Calugar

Dan Calugar is a versatile and experienced investor with a background in computer science, business, and law. He developed a passion for investing while working as a pension lawyer and leveraged his technical capabilities to write computer programs that helped him identify more profitable investment strategies. When Dan Calugar is not working, he enjoys spending time working out and being with friends and family and volunteering with Angel Flight.

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