Capturing Meteoric Gains

Lessons Learned

Don't you love to own stock where everything initially goes right? You buy at a great entry point and the stock moves ever higher. Dreams of newfound wealth put a spring in your step. Then, as is frequently the case, the high-flying stock falls back to earth. Paper profits evaporate. There must be a better way to lock in profits, but what cost? There is a multitude of strategies. We examine one easily executed strategy versus a simple buy and hold:

• Buy the stock and hold it no matter what. You plan to sell the shares in the longer term at full value.

• Take profits along the way at pre-arranged, profit-taking intervals.

The past two years provide a host of candidates to select; Zoom, Peloton and Shopify are prime examples.

Shopify was for a time the stock with the largest market capitalization in Canada. With its share price being volatile, it is a suitable candidate for analysis. The period selected was November 25, 2019, through May 11, 2022, as this time frame captures both the rise and fall of the shares. Shopify had a tremendous run-up until late 2021, as indicated in the chart. Followed, unfortunately, by a major correction.

The buy-and-hold investor experienced a maximum gain of 433% as the stock peaked, followed by a correction that reduced the investment by 81%. As of May 11, 2022, the position showed a gain of 0.50% over the selected period.

What about the "profit-taking" investor? If we elect to sell shares every time we experience a 10% increase over our cost base on Shopify, the maximum gain is 176%. With the subsequent drop in the shares, the drawdown from this peak level of profitability was 31%. Over the entire period, the holding appreciated by 90%.

The period selected and the 10% profit-taking trigger are subjective. Changing the period and the level at which one takes profits will produce different results. Nevertheless, continually reducing position size to your cost base is one method to lock in profits on highly volatile securities.

There is no perfect way to hedge the risk of seeing your profits erode. There is a cost to the profit-taking strategy; it reduces the potential to compound returns from an ever-increasing dollar position. But there is a peace of mind and satisfaction that comes from taking profits off the table.

Investors might also consider a Stop-Loss strategy where the stock is sold based on a pre-established decrease in share price. This will prove difficult with a very volatile stock. The first setback in the stock's valuation is likely to occur quickly and your hold period will be very short.

Private investors are not alone in struggling to control risk. The Financial Times recently disclosed that the Tiger Global hedge fund had reportedly lost $17 billion during this year's tech selloff. In terms of timing, FT further revealed that in just four months, possibly two-thirds of the gains in the hedge had been lost. Based on this report, the fund experienced substantial net gains for over ten years before the crash in asset value occurred.

Risk controls are vital for both self-directed investors and portfolio managers. These controls need to be in place even in the most bullish markets. The current price collapse of many high flyers has woken investors up to the risk involved in passively holding stocks with extreme volatility. Have a plan in place and stay disciplined for the next home run opportunity.

Tim Morton, CFA is a recently retired portfolio manager with 45 years of experience working with private clients and is the editor of mortonir.com