Profit-Taking

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.

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 (EPS), revenue growth, margins, or guidance).

A take-profit order (T/P) is a type of limit order that specifies the exact price at which to close out an open position for a profit. If the price of the security does not reach the limit price, the take-profit order does not get filled.

Types of Taking Profits

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 as a result of 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.