Here is a happy problem: You have a large instant gain from one of your stocks. What should you do?
The topic comes from an actual question raised at Scutify.com, where participants exchange ideas and get a wide range of opinions. (I get to play the role of the straight man in a world of day traders, revolutionaries, Bitcoin and gold zealots, and bubble callers. It is usually fun and there are some good ideas if you can sort through it all). The stock in question was trading about $4.00 yesterday and doubled in early trading because of a favorable ruling by an FDA Advisory Committee. Since I have nothing to add about the specific company, I am not going to name it. I want to use it as an illustration of how to think about risk and reward. (You can probably guess the stock, but please remember that my upside and downside targets are only illustrative).
For the purpose of this analysis let’s assume that the position size is appropriate for the trader or investor in question.
The Standard Answer
Most people would advise something like taking your original money off the table and playing with the “house’s money.” This gambling metaphor has broad psychological appeal. How would you feel if the stock dropped back nearly to zero?
We know from the behavioral finance literature that people are much more sensitive to losses than to potential gains. The psychology of this situation is powerful.
You could also add that the technical analysts might well be flashing warnings like the following:
- The stock is trading far above its 200-day (or 50-day or 200-week or X-day) moving average.
- The stock has a gap opening and the gap “needs to be filled.”
- Or the rally was mostly short-covering with a volume spike.
- And similar arguments.
The Fundamental Answer
A fundamental analysis starts with a fair value for the stock. In the case of a binary event – the drug is approved or it is not – the calculation is straightforward. Let’s do it both before and after the Advisory Committee decision.
