What is Profit Booking or Profit Taking?
Caught in the daily twists and turns of the stock market? Here are Profit Booking Strategies explained. What is Profit Booking? How does a stock market temporary falls are attributed by profit Booking? Averaging out selling reduces the risk that volatile markets impose on your profits, just like buying.
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 profits that they have created. It must be understood that for a profit booking, there has to be a profit involved.
- If stocks are liquidated and cashed out to avoid losses, then such a situation cannot be called profit booking. So, investor should not get confused between profit booking and stop-loss.
- Converting Notional Wealth into Real Wealth
- When stocks rise in value, the resultant wealth created is nominal wealth. This is because the price of stock is only a notion that can change at any point in time. Therefore the value is not stable and keeps on fluctuating. Any profits and losses calculations made using this value are merely notional.
- On the other hand, when the investments are liquidates, investors have hard cash in their hands. The value of hard cash does not fluctuate. Therefore the wealth created is real. Therefore, in other words, the transfer of nominal wealth to real wealth is nothing but the profit booking.
- Strong Fundamentals of Stock vs Temporary Fall due to Profit Booking
- When investors book profits, the money flows out of the market. Investors liquidate their shares for cash. Therefore, there is an inflow of shares and an outflow of cash. 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 as a result of profit booking are extremely temporary in nature.
- These issues get resolved and the stock price comes back to normal in a matter of days since there is no problem with the fundamentals of the stock. Profit booking are just temporary instability created by market sentiments.
When to Book Profits?
There are three main situations where the investors must not delay to book profits. These are as follows :
- Company-specific News
- If there is any positive news about the company, then it goes on to create a positive sentiment about the company in the market.
- For example, Share price of FMCG major Hindustan Unilever jumped almost 7% intraday on Tuesday, March 24. HUL was the top Sensex gainer after the company signed an agreement with Glenmark Pharmaceuticals to acquire its intimate hygiene brand ‘VWash’
- This leads to the excessive buying of shares among the investors, which may eventually rise in the prices of the shares. When the share prices are on the higher side, then the investors are able to meet their investment targets by selling the shares.
- Sector-specific News
- For example, Announcement of Tariff Hike by All Indian Telecom companies – Airtel, Reliance Jio, Vodafone Idea. A great rally was there after this Tariff hike announcement 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.
- There was rally of almost 20-25% due to the investors’ positive sentiments build for the Telecom sector. During such sharp rallies, many investors executed the profit-booking due to the uncertainty about the sustainability of the rally.
- Economic Indicators
- The economic indicators data of the country play a very important role in the case of the 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. GDP growth rate for Q3 FY2019-20 has come down to 4.7%.
- According to the economic data, the economy of the country is not performing well and the overall outlook is 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 key strategies for profit booking.
1. Rebalancing Portfolio – Constant Weight Asset Allocation
- Suppose, a portfolio Rs.1 Lakh of an investors is constructed with two asset classes – Equity and Debt.
- Equal amount is invested in equity and debt, 50%-50% in each asset class. If equity portion is appreciated in value, from Rs.50,000 to Rs.75,000, the portfolio of worth Rs.1.25 Lakh will have 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 switch towards Debt investments like Fixed Deposits or Debt Funds or Liquid Funds as per your preference.
- This is the principle of rebalancing where the objective of profit booking is to ensure that proportions invested in each category remains constant as decided originally.
- This portfolio rebalancing strategy once a year works out the best for the long-term, since there is no human intervention. Your portfolio will be driven by a disciplined approach of constant weight asset allocation.
2. Target Oriented Profit Booking Approach
- Here, an investor decides to cash-out the profits, if targeted returns are achieved in the schedule time horizon.
- For example, if 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 in 3-4 months. He will cash out the profits and invest in some other instrument.
- Residual Profit Booking
- This new Strategy is developing amongst the investors now-a-days.
- For example, if an investor targets 20% returns by investing Rs.1,000 in a stock for 1 year. After, 1 year the investor will cash out his principal of Rs.1,000 and will continue to invest the residual profit of Rs.200 in that stock to grow that profit in future with the price appreciation in the stock.
- However, be aware of the unnecessary aggregation or accumulation of stocks in your portfolio over the longer horizon.
What Retail Investors Should Do?
- Retail investors should not simply book the profits because the markets are performing well or are on the rise. Similarly, do not get panic when every other investor is selling the shares.
- You should keep your financial goals (long-term or short-term) into the mind. One should evaluate the performance of your model portfolio irrespective of the market conditions.
- A proper comprehensive stock research is required when it comes to selling the shares and book profits.
- An investor can get the best returns on their investments by booking the profits in a well planned and timely manner. It is always advisable to book profits on the small portions of the investments. This will benefit the investors in two ways :
- Partial profit booking will secure the profits on a certain part
- The rest of the investments will continue to grow for long-term financial goals