What Is Profit-Taking?
Profit-taking is the act of selling a security in order to lock in gains after it has risen appreciably. While the process benefits the investor taking the profits, it can hurt other investors by sending shares of their investment lower, without notice.
Profit-taking can affect an individual stock, a specific sector, or the broad financial market. If there is an unexpected decline in a stock or equity index that has been rising, with no news or external events to support a selloff, it may be attributed to many investors taking profits.
- With profit-taking, an investor cashes out some gains in a security that has rallied since the time of purchase.
- Profit-taking benefits the investor taking the profits but can hurt an investor who doesn't sell, as it pushes the price of the stock lower, at least in the short-term.
- Profit-taking can be triggered by a stock-specific catalyst, such as a better-than-expected quarterly report or an analyst upgrade.
- Profit-taking can also hit a broad sector or the overall market; in this case, it might be triggered by a bigger event, like a positive economic report or a change in Federal Reserve monetary policy.
Understanding Profit Taking
While profit-taking can affect any security that has advanced (e.g., stocks, bonds, mutual funds, and/or exchange-traded funds), people use the term most commonly in relation to stocks and equity indices.
A specific catalyst often triggers profit-taking, such as a stock moving above a specific price target; however, profit-taking may also occur simply because the price of a security has risen sharply in a short period of time. A catalyst that frequently triggers profit-taking in a stock is the quarterly or annual earnings report (SEC Forms 10-Q or 10-K, respectively). This is one reason why a stock may be more volatile in the weeks surrounding the period when it reports results.
If a stock has gained significantly, traders and investors may take profits even before the company reports earnings in order to lock in gains rather than risk profits dissipating if the earnings report disappoints. Investors may also take profits after earnings are reported to prevent further declines (e.g., if the company has missed expectations on earnings per share, revenue growth, margins, or guidance).
Taking Profits in a Specific Sector
Profit-taking in a specific sector—even against the backdrop of a strong bull market—could be triggered by an event specific to that sector. For example, a bellwether stock could report unexpectedly weak earnings in an otherwise hot sector, which could subsequently trigger profit-taking across the entire sector, due to fear. If a promising tech company had a poor initial public offering (IPO), investors might be keen to exit the sector overall.
If the profit taking is one-time event-driven—such as in response to a profit report—the overall direction of the stock is unlikely to change long-term, but if the profit-taking is in response to a bigger issue (such as worries about economic policy or other macro issues) longer-term stock weakness could be a risk.
Broad Market Profit-Taking
Profit-taking in the broad market is usually a result of economic data, such as a weak U.S. payrolls number or a macroeconomic concern (such as concerns over high levels of debt or currency turmoil). In addition, systematic profit-taking could occur due to geopolitical reasons, such as war or acts of terrorism.
It is important to note that profit-taking is typically a short-term phenomenon. The stock or equity index may resume its advance once profit-taking has run its course. Yet a concerted bout of profit-taking that knocks a stock or index down by several percentage points could signal a fundamental change in investor sentiment and portend additional declines to come.