Profit taking involves the sale of an asset after its value has risen higher than the original purchase price. By selling at this point, the owner realizes a profit on the sale. The term is most commonly applied to the sale of securities, where the profit taking event is usually driven by one of the following events:
The security price has risen sufficiently above the original purchase price and any sale transaction costs to generate a reasonable profit; or
There is an expectation that the security price is now maximized, and may begin to decline.
For example, a company issues a relatively weak quarterly earnings report. Based on the information in the report, investors feel that the stock price will not continue to rise, so they engage in profit taking to lock in their gains.
Profit taking is especially common in the following circumstances:
A general decline in the economy.
An industry is now subject to an increased amount of expensive regulation.
An industry is coming under profit pressure from outside the industry.
A company has missed on one or more of its key performance indicators.
When many investors decide to engage in profit taking, this can trigger a broad sell-off of securities, which can trigger a decline in the major stock market indices.