Observing The Dangers of Unrealized Gains

Prompted by an investment strategy discussion with an active U.S. capital market trader; the subject of unrealized gains proved to be a topic of conflicting opinions. In a passive portfolio many investors follow a certain schedule. There are times when liquidity becomes more desirable and there are times when the assets are merely left to the sways of the market. Each investor has their own routine trading patterns and practices to which they adhere, and different ways in which they approach unrealized gains. For an active portfolio manager buying and selling assets intraday at various price levels is nothing new. Occasionally a trader that normally profits on short-term gains, arbitrations, and microdynamic intraday market movements will encounter that one of their assets becomes intermediately valuable.

Tracking oscillators and using DOW theory can give an investor an appropriate measure of when to sell an asset before a correction – especially following several days of steady gains. However, sometimes an investor may experience an overlap in market correction, and positive fundamental performance or announcement drifts. Consider the following timeline:

– Day 1: Company posts 1.2% close.

– Day 2: Company posts 1.7% close.

– Day 3: Company posts 4.2% close.

There is clear momentum in the stock that has pushed it to a price level that some investors might consider to be overvalued. A natural correction will take place over the upcoming period. Days 4, 5, and 6, may not be as bullish as the previous days, but what if the schedule calls for an earnings report release on Day 6 before the market opens. The news is predicted to be good, but the stock is still caught up in its own recovery process.

– Day 4: Shares correct – closing -2.7%

– Day 5: Shares continue through the correction closing -2.5%

– Day 6: Shares are impacted by the correction, but investor sentiment remains positive: 2.3%

In this case the investor earns a return of 4.2%. Now, consider the following: The investor sells his shares at the end of Day 3, and buys the shares end of Day 5. Now the investor earns 9.4% on his investment by banking on his knowledge of oscillators.

Active portfolio managers are well aware of this. Especially when such short-term holding periods are considered an investor must rely heavily on technical analysis. This same principle can be applied to passive investment in times of a higher need for liquidity. Unrealized gains have the potential to bring down the overall profits of a portfolio, but active management using technical analysis allows a trader to avoid potholes on a winning stock’s road to success.

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