Why It (Almost) Never Hurts To Take A Profit
One of my favorite movies is the classic 80’s film Trading Places. Starring Dan Aykroyd and Eddie Murphy, it tells the story of a young commodities trader (Aykroyd) who is unknowingly subjected to a bet where he must trade places with a streetwise hustler (Murphy) in a cruel social experiment.
If you haven’t seen it, I highly recommend it. One line sticks out to me from the film, in which Aykroyd’s character laments how rapidly fortunes can turn.
“You make no friends in the pits and you take no prisoners. One minute you’re up half a million in soybeans, and the next, boom, your kids don’t go to college and they’ve repossessed your Bentley.”
This sentiment is true when dealing with the stork market. And it’s especially true when dealing derivatives contracts such as futures or options.
In this world, it only takes a couple of bad days to unravel a winning trade and turn a potential big gainer into a painful loss. But selling too early can also be frustrating if the stock (or option) continues to climb.
And if that weren’t enough, there are the times when you like a stock but don’t pull the trigger – only to watch it skyrocket. All you’re left with is woulda-coulda-shouldas.
The One That Got Away
Case in point, when I started scouting candidates for my new Takeover Trader service back in March, I had my eye on Shopify (NYSE: SHOP).
For those who don’t know, SHOP is a top provider of e-commerce software. It’s also your classic case of a “hot stock”. At the time, the stock was trading in the $350 range. Today, less than three months later, it’s within shouting distance of $800 per share.
At this price, SHOP is trading at roughly 1,500 times its projected annual earnings of $0.50 per share. The price tags on some teleconferencing and cloud computing stocks are equally steep.
As a value investor at heart, it’s not easy for me to pull the trigger on stocks trading at such nosebleed valuations. But it’s important to remember that growth is a component of value. After all, the intrinsic value of any business is a function of its future cash flows discounted back into today’s dollars.
All things equal, a company growing the bottom line at 30% to 40% annually should rightfully command a richer multiple than slower-moving rivals. As Warren Buffet says, growth and value are joined at the hip. For the record, analysts expect Shopify’s earnings to expand at a 60%+ pace over the next five years.
I should note SHOP has pulled back from recent highs as traders take some profits off the table. That’s a trend I’ll be watching closely, as this is an attractive portfolio candidate at the right price.
A Bird In The Hand…
I wish I would’ve taken the plunge with SHOP back then. But of course, hindsight is 20/20. And I haven’t let that stop me from finding other big gains in this recovering market.
To understand the struggle investors face, I’ll give you another example. A couple months ago, I told my readers about a growing logistics firm that I felt could be the perfect acquisition for a company like Amazon. (I still believe that, which is why we still hold an equity position in our portfolio, so you’ll forgive me for not giving away the name.)
Long story short, I told readers to buy call options that expire in November. Shortly after that, the stock went on a rally.
Before we knew it, our calls had risen by nearly 90%. Satisfied with a major gain in just a month, I told readers to sell.
But the stock continued to chug higher, and that same contract was as high as 160% above our initial entry at one point.
Do I hate to miss out on those extra gains? You bet. Nobody likes to leave potential gains on the table. But overstaying your welcome and possibly walking away empty-handed isn’t any better. As they say, nobody went broke taking a profit.
Here Are Some Steps I Take
Rather than leave you with that, though, I want to offer some practical advice.
In many cases, a holding can reach your target price (something you should always have in mind) and continue to move higher. After all, stocks can get over-extended to the upside just as they do to the downside.
So instead of selling outright, I like to use a 10% or 15% trailing stop loss. This tactic lets me stay on board the rally, but automatically exit whenever the security retreats a predetermined percentage from its peak.
Sometimes, I also like to split the difference with my position. By that I mean cashing out profits on part of my position while letting the rest ride.
In fact, that’s exactly we with call options on our energy pick over at Takeover Trader.
In my original writeup, I said that shareholders will be well-rewarded over the next couple of years. As it turns out, we didn’t even need a couple of weeks. The stock made a strong upward move since then, driving our call options up 163% in just eight trading days.
In that case, my spidey-sense was right. The options opened down 20% the next day.
Now, some of my followers were able to get out in time and some weren’t. But that’s OK. The point is that we booked a fat profit. And we need to be okay with that.
[If you want to take it a step further, my colleague Jimmy Butts wrote about a good idea called the “rule of thirds” in this article.]
Action To Take
Ultimately, the timing of any buys/sells is your decision. My job is to feed you ideas to put into action based on your own unique investment objectives and risk tolerance.
But the main thing I want you to take way from this is that I don’t want you to get too greedy in the middle of this impressive rally.
Sure, there could be more gains ahead. But you should exercise caution.
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