Today’s post comes courtesy of Troy at The Financial Economist:
As you probably know, Jay recently wrote a post about the wild bull market we’ve been experiencing lately. In response to this, I figured I’d write a guest post about taking profits in this bull market, since (if you’ve read my blog) I’m rather bearish on this bull market.
The reason for my bearishness is rather simple – I think that this stock market is way overbought, thanks to the Federal Reserve’s crazed stock manipulation. The economic news is terrible, corporate earnings have all missed revenue expectations, yet the stock market is on a tear. Does that make any sense? Absolutely not!
However, astute investors have said that “the market can stay irrational longer than you can stay solvent”. Thus, I am not going to short stocks now. I’m too young to die. For investors that still hold stock positions, here are 3 strategies on how to take the MAXIMUM amount of profits in a bull market.
Sell It All
The first strategy is pretty self-explanatory. When the bull market is getting crazy (as I think it is now), just sell all of your stock holdings. Essentially this type of selling reveals the investor’s mentality: I don’t know when this bull market will end, and I certainly don’t want to stick around to find out. Now this strategy has a couple of advantages and disadvantages.
The advantage is that if you sell all of your holdings right now and (by luck) you just so happen to sell at the peak, then that’s great for you! Had you held onto your stock holdings a little longer, your paper profits would have evaporated very quickly once the bull market gave away to the bear market.
The disadvantage is that if you sell all of your holdings now but the bull markets continue running apace, two very painful and dangerous things happen.
- You’re missing out on potential profits that you could have made had you not sold out all your stock.
- What’s worse is the regret and the emotional aspect of this “could have” mentality. A lot of investors sell just when the market starts getting euphoric, and painfully watch the market rise day after day after day from the sidelines. Soon enough, they can’t stand NOT BEING in the market, and buy, conveniently right at the top of the bull market. This scenario happens far too often to young and old investors alike.
One Step at a Time
The second strategy is my preferred strategy – you sell a bit of your stock holdings at a time when the market is moving up. For example, let’s say that the S&P500 is euphoric right now. Knowing that this bull market is in danger territory, I might choose to sell 25% of my holdings. When the market moves up another 5%, I’ll sell another 25%. Another 5% for the S&P, and I’ll sell another 25% and so on. This has one disadvantage compared to the first strategy, but all in all it is handily preferable over the first.
The obvious disadvantage is that if the first 25% that you sold just so happened to be at the market peak, then you can’t catch the market peak for the other 75% of your holdings – you’ll have to sell at lower prices. However, this disadvantage isn’t too significant, because let’s be honest guys. What are your chances of actually selling right at the top of the bull market anyways? Slim to none.
However, this method of taking profits is highly attractive, both financially and emotionally. It avoids the 2 pitfalls that the first strategy has:
- Should the market continue to rise, at least you didn’t sell all of your holdings. You’re still making some profits, although not as much as you could have were you to not sell any of your holdings.
- This is also emotionally VERY SAFE. When the market continues to rise and you’re at least still making some money, you won’t be so prone to chasing after the market (and conveniently buying at the market top). Investing is all about managing your emotions – this profit taking method does just that.
Options Combined With Strategy #1
This is a more complex way of taking profits that I know some investors use. Essentially, this is exactly the same as the first strategy – you sell all your stock holdings when the market starts getting euphoric. HOWEVER, to hedge your bets in case the market continues to rise, you buy call options. Call options are essentially the right to buy a certain stock at a future date based on today’s price. (Ed. Note – Check out my primer on covered calls for more.)
But of course, the right to do this has a cost, and that is known as the premium. The higher the premium, the more expensive this option will be for you (the investor).
Personally, I don’t really like this strategy, because call options are extremely expensive in bull markets. Because the seller of the call option knows that the market will very likely rise, to minimize his potential losses he will charge you (the investor) an exorbitant premium, making it very expensive to buy a call option.
Are you taking any profits due to the recent run up in the stock market? If so, what strategies are you using to do so?
Like this post? Feel free to check out Troy’s blog about finance, investing, and insights on global economic events at http://www.thefinancialeconomist.com/. In addition, he discusses his views on the stock markets and his thoughts on how certain political actions can impact the global economy (and therefore your finances). Cheers, and thanks for reading!