Partial Profit Taking: What To Do When You're Sitting On Gains
by Marc Lichtenfeld, Advisory Panelist
Saturday, August 8, 2009: Issue #1061
Editor's Note: On August 15, we'll be expanding our expert list to include Karim Rahemtulla, Lee Lowell and healthcare and biotech expert Marc Lichtenfeld. They'll be joining our current experts in providing you the best investing ideas and investment education every day. Recently, Marc showed his readers how he locks in his profits in hot biotechs. With a number of small caps exploding upwards over the last few weeks, we felt it's time to revisit this partial profit taking strategy.
So your stock just went way up, now what do you do? We often hear from concerned investors who aren't sure whether to hold on or sell it all after a huge gain.
For example, I'm used to explosive gains in the biotech world, but I've never seen a moonshot quite like this one...
Shares of Vanda Pharmaceuticals (Nasdaq: VNDA) rocketed up by 625% on news that the company's schizophrenia drug, Fanapt, was FDA-approved. Earlier, the stock had opened at $9.99, having closed at $1.08 per share on Wednesday night - that's a massive 825% spike.
Even for a biotech veteran like me, a one-day percentage move like this is unprecedented.
When you reel in a big winner, you need to know when to dash off with the money. We recommend investors use trailing stops to help the lock in profits and prevent losses, but there is another strategy you can use when you see one of your holdings take off on you and that is to take partial profits.
Partial Profit Taking Lowers The Inherent Investing Risk
All investing carries inherent risks, even more so when we deal with small-cap stocks and the volatile biotech sector. We want to lower that risk whenever possible. However, that doesn't mean we avoid risk all together - on the contrary.
It means that any position we enter should have significant upside potential to offset that risk. The more risk... the more profit potential I need to recommend the stock.
Sometimes, good news is already priced into a stock. In the case of Vanda Pharmacueticals, it clearly wasn't. The reason why VNDA shares were so explosive is because virtually no one expected Fanapt to get the green light.
No doubt some VNDA investors were popping champagne corks, following the small-cap biotech's liftoff. It's probably made their year.
Others, however, are still trying to recoup their losses from the stock - even after today's monumental surge. That's because two years ago, VNDA was trading around $25.
Many investors who use trailing stops also pull money off the table when they feel a stock has moved up considerably - It could have helped VNDA shareholders two years ago.
Taking some money off the table when you're up is another way to lock in your gains and "sell high." Unfortunately, many investors don't.
The Four Purposes of Partial Profit Taking
I'm a big proponent of partial profit taking on a winning position when appropriate. If a small-cap biotech stock is up significantly, locking in some gains serves four purposes:
- Returns Investment Capital: While remaining in the position, I now have capital to put into other opportunities.
- Helps Weather The Downside: If I still believe in the company and the investment, partial profit taking allows me to give the stock more room to fluctuate, as I'm no longer concerned with losing my original investment. It makes it possible to loosen up my trailing stops.
- Participate In Upside: Having secured my original investment, I can now allow my winners to run. That's where truly large gains happen.
- Removes Emotion from your Decisions: An unemotional investor is a smart investor. Knowing that you're playing with "the house's money" can allow you to make decisions based off your risk tolerance and investment horizon, not emotion.
Recently, when I recommended that subscribers take partial profits in a top-performing stock, I received a ton of email asking why... particularly when I expect the stock to go significantly higher.
I emphasized the reasons above - that taking some profits lowers our level of risk, while still allowing us to go for the home run.
I'll give you another specific example...
In my small-cap healthcare service, we took 65% gains in half our position in SIGA Technologies (Nasdaq: SIGA). That's allowed us to let the stock run to current levels, which are now 158% above our entry price. It also allowed us to use that money for a number of other winners.
So while VNDA blasted its way higher, remember that it's a perfect example of how volatile the market can be - and how things don't always happen the way you expect.
One of the best ways to make sure that volatility doesn't negatively impact your portfolio is to play with the house's money whenever possible.