What Is it to Let Your Profits Run?
"Let your profits run" is an expression that encourages traders to resist the tendency to sell profitable positions too early.
The flipside of letting profits run is to cut losses early. The way to make money as a trader, according to many, is to follow both of these pieces of advice: to let winners (profits) run their course, and to cut losing bets before they spiral into deep losses.
- "Letting your profits run" is the advice given to traders to resist the impulse to sell winning positions too early.
- In general, there are three primary reasons for a long-term investor to sell: the buy was a mistake, the price has risen dramatically too quickly, or the current price is no longer supported by fundamentals.
- Emotion and human psychology can sometimes get in the way of making a smart decision to sell or hold.
Understanding Let Your Profits Run
While this advice is offered by many, it is followed by few. This is because it is more difficult than it may appear. Most traders tend to take gains off the table early out of fear that they will evaporate quickly. They also tend to hold onto large losing positions in the hope that they will rebound.
Instead of letting profits run, some traders prefer to have a target exit point that will lock in a predetermined profit. Likewise, traders often use stop-loss trading that automatically enables them to exit a trade if a decline of a specified amount occurs.
Trading is generally considered a difficult skill to master and one that cannot be boiled down to a simple maxim. Successful traders are highly knowledgeable about the markets they trade whether stock, options, currencies, or commodities. Knowledge of common trading patterns both of specific securities and of the market as a whole is critical. Successful traders typically have gained this knowledge via education and real-world experience.
When to Sell a Stock and Trading Psychology
One reason why people flip the advice they are given and cut losses early while holding too long on to losers has to do with what behavioral economists have identified as loss aversion. This means that a potential loss is more psychologically harmful than an equivalent gain.
As a result, people will tend to hold on to losers or even double down with the hopes of breaking even again, often taking on too much risk. At the same time, people will fear that small gains will evaporate and lock them in too soon. In trading, this is known as the "disposition effect."
There are generally three good reasons to sell a stock:
- Buying the stock was a mistake in the first place.
- The stock price has risen dramatically.
- The stock has reached a silly and unsustainable price.
While there are many other additional reasons for selling a stock, they may not be as wise of investment decisions.
Here's an all-too-common scenario: You buy shares of stock at $25 with the intention of selling it if it reaches $30. The stock hits $30 and you decide to hold out for a couple more gains. The stock reaches $32 and greed overcomes rationality. Suddenly, the stock price drops back to $29. You tell yourself to just wait until it hits $30 again. This never happens. You finally succumb to frustration and sell at a loss when it hits $23.
In this scenario, it could be said that greed and emotion have overcome rational judgment. The loss was $2 a share, but you actually might have made a profit of $7 when the stock hit its high.
These paper losses might be better ignored than agonized over, but the real question is the investor's reason for selling or not selling. To remove human nature from the equation in the future, consider using a limit order, which will automatically sell the stock when it reaches your target price. You won't even have to watch that stock go up and down. You'll get a notice when your sell order is placed.
Frequently Asked Questions
Why should I let profits run if a stock is up?
You should typically only sell a winning position if the price has risen to your target or to where fundamentals support. If fundamentals do not support a rally or it has reached or exceeded your target price, by all means, sell. Otherwise, people tend to sell their winners too early. To avoid selling too early, you should hang on until some objective (and not emotional or psychological) price level.
What if things change and my target price is revised lower?
As market dynamics change, you should also revise your exit point and sell when appropriate.
What is the disposition effect?
The disposition effect in behavioral finance describes a type of loss aversion whereby traders hang on to their losers for too long and sell their winners too early. This psychological bias, where losses loom larger than gains, can be detrimental. Letting profits run and cutting losses is the better and more rational strategy - but psychologically more difficult to execute in practice.