As an investor, it is crucial to understand the dynamics of the stock market and how to make informed decisions to maximize profits. One aspect that often confuses traders is when to take off profits during a strong rally in a stock. In this article, we will discuss the concept of allowing winners to run while letting go of your losers early.
The Nature of Market Cycles
To grasp the concept of allowing winners to run, we must first acknowledge the nature of market cycles. In every asset class, including stocks, there are periods of excesses and subsequent corrections. This pattern holds true for gold, real estate, and various other investment vehicles. Stocks, in particular, tend to oscillate between periods of under or over-ownership and undervaluation or overvaluation.
Understanding this cycle is crucial for investors because it highlights the potential for profits during a stock’s rally phase. By allowing winners to run, investors can take advantage of the momentum and ride the wave of success.
Let us take the case of IRCTC
Let’s examine the case of Indian Railway Catering and Tourism Corporation (IRCTC) to illustrate the concept of allowing winners to run. In December 2020, the stock began a significant rally from Rs250, eventually reaching Rs400. At this point, some investors might have considered taking profits.
However, the stock continued to surge, reaching as high as Rs1250. If traders had exited their positions during the initial correction, they would have missed out on substantial gains.
It is essential to let the stock consolidate and closely monitor the momentum. By following a momentum strategy, traders could have exited at an ideal point, capturing a significant portion of the rally without enduring the subsequent pain of the market correction.
Momentum Investing could’ve held you avoid this weak phase in IRCTC by exiting a loser early and allocating that capital to another potentially stronger stock.
It is important to acknowledge that there will be periods of exuberance in the market, accompanied by over-ownership and super overvaluation. However, as momentum investors, our focus should be on maximising profits rather than preempting when a stock will top. The aim is to capitalise on the stock’s growth until it shows signs of a reversal.
It is understandable to be hesitant about digesting substantial gains, especially when a small investment proves miraculous. However, rather than trying to predict the future, it is better to let the stock dictate its performance. If a stock demonstrates it no longer wants to go up, it is a sign to exit the position. This approach ensures that traders do not leave significant gains on the table and consistently reap profits.
Examples of Rail Other Stocks
IRCTC is not an isolated case; numerous other stocks exhibit similar patterns. RailTel, for instance, experienced a two-year consolidation period from March 2021 to March 2023, trading within the range of 90 to 150. Following this phase, the stock began a substantial uptrend, surpassing 250 and continuing to rise.
Another example is IRCON, which remained stagnant around Rs40 for an extended period. However, it experienced a re-rating that drove the stock up to 157.
Similarly, IRFC and RVNL went through consolidation phases, followed by explosive rallies. These examples demonstrate the importance of allowing winners to run and not prematurely exiting positions.
The Risk-Reward Balance
To implement a successful momentum strategy, it is crucial to strike the right risk-reward balance. As an investor, you must be willing to take the risk of losing some of the gains you have made while holding a stock. The possibility of losing a portion of your profits is by design and an inherent part of momentum investing.
By accepting this risk, you open yourself up to the potential of hitting a home run and achieving exceptional returns. It is unrealistic to expect stocks to continue soaring indefinitely without any hiccups. Therefore, maintaining realistic and optimistic expectations is vital in momentum investing.
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