The popular wisdom in the stock markets is that smart trading is all about profit maximization for a given level for risk. With the Nifty and the Sensex at all-time highs, the debate over when to book profits is back. Remember, your profit booking decision need not always be a macro decision. Your core aim is maximum Returns on stock markets and hence there could be a variety of triggers to take profits off the table. These factors could be macro level factors (growth, liquidity, and inflation), industry level factors (regulation, demand, supply) or even company specific factors (growth, profits, product obsolescence).
As a trader, you make returns on the stock market only when you reverse your trade. That decision involves a major trade off. You do not want to book profits on a stock and then see the stock appreciating another 10% in the next few days. You also do not want to hold on to a falling stock for too long in the hope that it will bounce back. So what exactly should traders do and how do they identify credible signals to take profits off the table?
Six Signals to take profits off the table
1. The first signal to take profit off the table is if the stock is losing momentum at higher levels. Remember, bull rallies do not come to an end when selling emerges. On the contrary, bull rallies come to an end when buying vanishes. These signals are very hard to miss. Check out the history of stocks in the IT and pharma stocks that went into long term downtrends between 2015 and 2017. There was clear absence of buying that was evident on these stocks well before the actual selling started on these stocks. When you find the stock consistently losing momentum at higher price levels, it is a classic signal for you to take profits off the table. This rule applies at a company level as well as at an industry level.
2. The second signal is the “churn versus hold” rule on stocks. This rule is slightly more complicated because it is slightly more intuitive and entails a lot of individual judgement. To understand this rule, one needs to understand the “Rule of 72”. In finance parlance the Rule of 72 is used to calculate how many years it takes for your money to double. For example if you earned 12% on equities last year then it will take you 6 years (72/12) to double your money. This is an approximation and gives a fairly accurate picture. Now assume that you got into a trading position and made20% profits in a month. As per the rule of 72, you will double your money in 3.6 months (72/20). But then real markets do not work purely on mathematics! So, how you apply this rule is to ask yourself whether it is possible to earn 100% in 3.6 months by holding on to the position. If not, it is signalling to take profits off the table. That is the best route to profit maximization.
3. The third signal is that, if something is too good to be true, then it is probably not true. It is likely that you took a trading position projecting a return of 10% in one month. If you end up with 10% return on the stock market trading in just 5 days, then what should you do? The answer is that it is too good to be true hence you must take profits off the table. The same rule must also be applied when you make abnormally high profits on mid-cap stocks and in stocks where you are not fundamentally convinced. These are signals to take profits off the table.
4. Fourthly, you must watch out for some basic technical signals. A rising stock that makes higher tops is a positive signal. Similarly, a falling stock that is making lower bottoms is a negative signal. In the same breath, stocks that are consistently breaching their long term moving averages on the downside signal underlying weakness in the stock. Also stocks that show spurt in volumes when they fall and weak volumes when they bounce are a basket case of underlying weakness. As a trader, you must take the first opportunity to take profits off such stocks.
5. Fifthly, remember that your trading decisions are not about how attractive a stock is or how good the market is. The primary object must be to protect your capital. Therefore, you must constantly evaluate your portfolio. Does your trading position overly expose your capital to downside risk? Are your trading positions very vulnerable to black swan events? Is the worst case loss on your portfolio more than your normal cushion on capital? If your answer to any of these questions is “Yes”, then it is time to take profits off the table. Remember, protecting your capital is the first and most important step to profit maximization.
6. The last and the most important signal for you to take profits on your trading position is the liquidity in the market. Watch out for factors that can constrain liquidity. If FII flows and DFI flows are slowing, it is a sign of tightening liquidity in the markets. Similarly, if the RBI is tightening liquidity or increasing rates, then it is a sign that liquidity in the system could reduce. Keep an eye on the call money rates. If these rates are shooting up due to poor liquidity, then it is time to take profits off the table. As a trader, tightness in liquidity is bad for your trading positions, irrespective of whether you long or short in the market. The sheer volatility can hit you both ways and booking out is the best option.
In a nutshell, there are a number of very obvious signals that can goad you to book profits on your trading position. As a good trader your job is to listen to these signals thrown by the market and act on them. Returns on stock markets for the trader will follow as a logical corollary!