What is Profit Taking?
The term ‘Profit Taking’ means selling the investments held once it reaches the expected level of price for the sake of earning a profit; in other words, everybody wants to achieve maximum possible gains on their investments so, and to maximize the gains, the investor sells out the investments held and made profits upon the sell of such securities or investments.
An investor who invests in the securities of any company will always want to increase the price of such deposit to higher levels, which gives their expected rate of return, so when the security reaches such high prices, the investor sells off such securities and books profits thereupon.
How to Take Profits?
The profit-taking may be done using the following methods:
- First, the investor may keep a good watch on the prices of securities and keep updated with the industry’s news, which might be favorable or unfavorable.
- Sometimes, some broking house gives their investors an option to place a bid which automatically executes when the price of securities hits such bid price; under this option, the investor need not have to keep himself struck in the ups and downs of the price of the security as he has done with placing the bid now when the work of broking house starts they have to keep watch of the same and execute the trade on behalf of the investor and let them sell the securities at a price required by them.
Examples of Profit Taking
Suppose Mr. A has purchased 10,000 shares of XYZ Inc. at $500 each on 01.04.2020. Mr. A wants to retain such shares until the price of a share reaches $750 per share. XYZ Inc. is in the business of manufacturing reusable bags. On 17.08.2020, the government policies have been changed and announced that only reusable bags should be used from now onwards, and all other types of bags should be banned immediately.
Now, due to such changes in policies, the price per share of XYZ Inc raises to $950 per share, showing a sudden rise of $350 per share; in such a situation, Mr. A has the option of profit-taking and earning a profit of $450 per share by enjoying the benefits of such high prices. In this situation, Mr. A earns an extra profit of $200 per share, amounting to $2,000,000. In this example, we could see that the target price of Mr. A is $750 per share, but due to favorable policy changes by the government, the cost of share suddenly rises to $950 per share, which is $200 over and above the target price set by Mr. A.
Profit Taking Strategies
There are different types of profit-taking strategies, which are as follows:
- Strategy in which the investor wants a limited return: Suppose an investor buys a security for $100 and wants to wait till it reaches $200. The investor will sell the securities purchased when it comes to $200.
- Strategy in which the investor waits to reach such high prices to earn the maximum possible profits: In this situation, the investor takes a high risk and remains till the security goes such new hiked prices and wants to take profit on such high prices, it satisfies the quote “higher the risk, higher the return.”
- By selling off some out of total quantities to take profit on securities partially: Under this method, suppose Mr. A has purchased 500 shares for $400 per share and wants to hold them till it reaches $600 per share now, the price of the share rises to $650, in this method the investors sells of partial shares say 300 shares and holds remaining shares to take some risk and earn more.
Importance of Profit Taking
The importance of profit-taking is as follows:
- The strategy of profit taking is essential as the value of securities in the open market needs to be corrected from time to time and keep it away from just pushed values.
- It gives the short-term investors a good or may be called a higher rate of return, which shall create a good image of the company in the eyes of an investor, and it may result in investment for the long term.
Advantages and Disadvantages
Below are the points that explain the advantages and disadvantages:
- The primary benefit of profit-taking is that the investor sells their investments at higher rates, and when the prices of securities fall, they repurchase the same at much lower prices.
- It sometimes gives the investor a more than expected rate of return and will be able to earn more profits due to the sudden rise in the prices of securities.
- As some investors start profit-taking, the security price tends to decline due to the heavy load of selling in such a situation.
- As compared to retaining investments and selling them after a long span which will result in long-term profits, selling the securities on such shorter rises resulting in short-term profits will be chargeable at high rates of taxes, to say, short-term profits will be taxed at higher rates of taxes as compared to long term gains which are taxed at less rate.
To conclude, the term ‘Profit Taking’ is when the investor redeems its investments at such high prices, which suddenly raises the purchase price and book profits. For example, the price of securities may suddenly rise because of any reason, such as positive news relating to the company, good financial results, government policy favoring the company, etc., because of which the price of security suddenly rises, and the investor sells of securities at much higher prices and starts making profits.
This is a guide to Profit Taking. Here, we discuss its explanations, examples, strategies, and importance with advantages and disadvantages in detail. You can also go through our other related articles to learn more –