Profit Booking Strategies Explained

Introduction

If you’re a regular investor, you may have noticed that it’s common for experts to attribute declines in the market to profit-taking. But what exactly is “profit-taking?” In this article, we’ll explore the term book profit and answer questions like what is book profit means? How to book profit in the share market? When to sell a stock for profit? Notional profit meaning and so on.

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Profit Booking Strategies

What is Profit Booking or Profit Taking?

Profit booking, also known as profit-taking, is when individuals or companies liquidate their holdings to cash out the stock market profits that they have created. It must be understood that there has to be some profit involved in for-profit books. If stocks are liquidated and cashed out to avoid losses, then such a situation cannot be called profit booking. So, an investor should not get confused between share market profit booking and stop-loss.

Converting Notional Wealth into Real Wealth

When stocks rise in value, the resultant wealth created is nominal. This is because the stock price is only a notion that can change at any time. And that is why the value is not stable and keeps on fluctuating. Thus, any profit or loss calculation made using this value is merely notional. On the other hand, investors have hard cash in their hands when the investments are liquidated. The value of hard money does not fluctuate. Therefore the wealth created is real. In other words, the transfer of nominal wealth to real wealth is nothing but profit booking.

Strong Fundamentals of Stock vs Temporary Fall due to Profit Booking

When investors book profits, the money flows out of the market and investors liquidate their shares for cash. Therefore, there is an inflow of claims and an outflow of money. This situation leads to the price of the stocks falling. When many investors give way to profit-booking, the market plunges. However, the market falls thus created due to profit booking are highly temporary. These issues get resolved, and the stock price returns to normal in a matter of days since there is no problem with the stock’s fundamentals. Profit booking is just temporary instability created by market sentiments.

When to Book Profits?

There are three main situations where the investors must not delay booking profits. These are as follows :

1. Company-specific News

If there is any positive news about the company, it creates a positive sentiment about the company in the market.

For example, the Share price of FMCG major Hindustan Unilever jumped almost 7% intraday on Tuesday, March 24. After signing an agreement with Glenmark Pharmaceuticals, HUL was the top Sensex gainer to acquire its hygiene brand ‘VWash. This led to the excessive buying of shares among the investors, which eventually led to the rise in prices of the claims. Investors could meet their investment targets when the share prices were higher by selling the shares.

2.   Sector-specific News

Just as there can be positive news for a single company, there can also be positive news for an entire sector. The first reaction will be an increase in price, and this is followed by a peak. Then comes the selloff, which results in a temporary slump.

For example, Announcement of Tariff Hike by All Indian Telecom companies – Airtel, Reliance Jio, Vodafone Idea. A great rally was organized when this Tariff hike announcement was done by Telecom players. Market had immediately done the factoring of the rise in the profitability and its positive impact on those Telecom companies’ market valuation could be seen. There was an almost 20-25% increase in the rally due to the investors’ positive sentiments built for the Telecom sector. However, many investors executed the profit-booking during such sharp rallies due to the uncertainty about the rally’s sustainability.

3.   Economic Indicators

The economic indicators data of the country play a vital role in the case of profit booking.

For example, BSE Sensex was rallying around 41,000 to 42,000, touching new highs, when December 2019 quarter GDP numbers were released. Gross Domestic Product or GDP growth rate for Q3 FY2019-20 had come down to 4.7%.  According to the economic data, the country’s economy was not performing well, and the overall outlook was negative. Still, the market (Sensex) was rallying above 41,000. The GDP data compelled the investors to sell their shares at those price levels prevailing in the market. Investors were selling the shares at those prices, and thus they locked their gains and safeguarded themselves from any financial loss.

Profit Booking Strategies

There are 2 critical strategies for profit booking.

1. Rebalancing Portfolio – Constant Weight Asset Allocation

Suppose a portfolio of Rs.1 Lakh of investors is constructed with two asset classes – Equity and Debt. An equal amount is invested in equity and debt, 50%-50% in each asset class. If the equity portion is appreciated, from Rs.50,000 to Rs.75,000, the portfolio worth Rs.1.25 Lakh will have a 60% portion in Equity. This appreciation to 60% from 50% earlier represents “Overweight” in equity. The investor should book some of the profits in equity and move the money into Debt instruments to attain the original 50%-50% weight asset allocation, converting notional gains from Equity investments into real gains by cashing out the profits and switching towards Debt investments like Fixed Deposits or Debt Funds, or Liquid Funds, as per their preference. This is the principle of rebalancing, where the objective of profit booking is to ensure that proportions invested in each category remain constant as decided originally. Once a year, this portfolio rebalancing strategy works out the best for the long-term since there is no human intervention. Your portfolio will be driven by a disciplined constant weight asset allocation approach.

2. Target Oriented Profit Booking Approach

Here, an investor decides to cash out the profits if targeted returns are achieved in the scheduled time horizon. For example, an investor targets 20% returns by investing in a stock for 1 year. He will book the profits as soon as his 20% target returns are achieved, whether in 1 year or 3-4 months. He will cash out the profits and invest in some other instrument.

3. Residual Profit Booking

This new Strategy is developing amongst the investors nowadays. For example, an investor targets 20% returns by investing Rs.1,000 in stock for 1 year. After 1 year, the investor will cash out his principal of Rs.1,000 and continue to support the residual profit of Rs.200 in that stock to grow that profit in the future with the price appreciation in the store.  However, be aware of the unnecessary aggregation or accumulation of stocks in your portfolio over the longer horizon.

What Should Retail Investors Do?

• Retail investors should not simply book the profits because the markets are performing well or rising.
• Similarly, do not panic when every other investor is selling the shares. You should keep your financial goals (long-term or short-term) in mind.
• One should evaluate the performance of their model portfolio irrespective of the market conditions.
• Proper comprehensive stock research is required to sell the shares and book profits.
• Investor can get the best returns on their investments by booking the profits well planned and timely.
• It is always advisable to book profits on the small portions of the assets. This will benefit the investors in two ways :

 1. Partial profit booking will secure the profits on a particular part.

             2. The rest of the investments will continue to grow for long-term financial goals.