Locking in profits refers to the realization of previously unrealized gains accumulated in an investment by closing all or a portion of the holdings. When an investor holds an open position, they may accumulate unrealized or paper gains or losses that aren’t recognized until the position is closed. For instance, an investor with a long position on a security can lock in profits by selling their stake for a gain. This action prevents them from being impacted by future changes to the security’s value.
This process is also known as realization or taking money off the table.
Key Takeaways
- Locking in Profits involves realizing previously unrealized gains by closing all or a portion of investment holdings.
- Investors accrue unrealized gains or losses while holding an open position, which are only recognized once the position is closed.
- The primary reason investors lock in profits is risk reduction.
- Also known as realization or taking money off the table.
Understanding Locking in Profits
Investors and traders may lock in profits for various reasons, but overwhelmingly, it is to mitigate risk.
Long-Term Investors and Portfolio Balance
Long-term investors might lock in profits to maintain the desired balance of their portfolios. For example, how might someone who started with a balanced portfolio of five funds behave if one fund outperforms the others, increasing its portfolio allocation from 20% to 30%? They may choose to lock in a portion of the profits from the outperforming fund and redistributing those proceeds to other funds. Doing so helps maintain a balanced portfolio, minimizing risk and optimizing potential profits.
Short-Term Traders and Immediate Gains
Short-term traders frequently lock in profits for income generation and to lessen risks. Suppose a trader enters a long position after a positive earnings report with specific price targets in mind. Upon reaching the first price target, they might sell a third of their position, leaving the remaining two-thirds to aim for higher targets. This strategy enables them to ’take some money off the table,’ reducing potential losses if the stock price reverses direction.
Both traders and long-term investors rely on strategies to lock in profits—traders typically use price targets set through technical analysis and indicators, while investors consider risk tolerance and asset allocation when deciding to realize gains.
Example of Locking in Profits
Imagine you buy 100 shares of Acme Co. for $12 each, and the stock price rises to $36 within two days. All potential profits are unrealized because you have not sold any shares. If the stock’s price falls, your unrealized profits will decrease, and if the price rises, your potential gain increases.
To lock in profits, you decide to sell 50 shares, yielding a profit of $1,800 (50 shares x $36 per share). Even if the stock price were to drop to $1 afterward, you would’ve still realized gains, effectively playing with ‘house money’ for the remaining shares.
Investing carries risks, including possible principal loss. Any given financial strategy should fit your personal investment goals and risk tolerance.
Related Terms: unrealized gains, open position, risk tolerance, asset allocation, technical analysis.
