After slumping into bear market territory during the first six month of this year, stocks rallied in July and have extended their gains so far into August. This leaves many investors with a dilemma — albeit a good problem: When is the right time to pare back winning positions and take some profits?

Unfortunately, there are no hard and fast rules for the right time to sell rising stock. What works for us here may not work for others, depending on risk-reward profile and investing time horizon. At the end of the day, sometimes investing can be more of an art than science.

Because of that, what we would like to do is set up some basic questions for everyone to ask themselves when considering a trade. These are not inclusive, but are a good starting point to keep us disciplined and leave out emotions.

1. Has the risk-reward profile become less attractive?

If a stock keeps moving to the upside without anything supporting the change, its valuation can start to look pricey. This is where understanding a stock’s valuation is helpful. To gauge whether a stock is appropriately priced, you can use the price-to-earnings ratio, a valuation metric found by taking a stock’s market price divided by the company’s earnings per share.

• The stock’s current P/E ratio should be compared to its own historical P/E ratio, the P/E ratios of its industry peers, and its earnings growth rate. This comparison can help you determine whether you are overpaying or underpaying for a stock at its current price.

• A high P/E ratio means investors are paying more for each dollar of company earnings. It also suggests that investors are willing to pay up for what they expect will be higher future earnings.

Stocks become overvalued when their prices rise faster their than their earnings estimates. A very high P/E compared to a stock’s peers could mean that its price may not fully justify its earnings potential. In this scenario, you are taking on more risk with the stock. The stock may be trading at a premium, reducing your risk-reward potential. This could be a chance to lock in some gains and rebuild your cash position.

Consider: stock XYZ has a $1 per share earnings estimate and is trading at $10 per share. This implies a 10 times price to earnings multiple ($10 share price divided by $1 earnings-per-share). If the stock jumps to $15 but there is no material news and earnings estimates remain at $1, the stock is now trading at 15 times earnings. In other words, the stock is now 50% more expensive and it could be time to sell for some profit.

On the other hand, if Wall Street analysts estimate XYZ company could generate $1.50 in earnings and the stock rises to $15, it is still valued at 10x earnings ($15 per share dividend by $1.50 eps). In this case, sticking with your position is justified.

2. Is the market overbought?

In the day and age of everything ETF, most stocks often move together. For example, Apple (AAPL) has a weight in the S&P 500 of ~7%. When the stock of Apple rises, it helps the S&P 500, which will also help other stocks in the basket as well. That is why we often refer to the term "market" because the overall investing environment is very important for individual stocks. Think "when it rains everyone gets wet." 

One specific indicator we often follow is the S&P 500 Short Range Oscillator, which is something you have to pay for, but often we're willing to share:

• The oscillator, which is updated every day after market close, is a market indicator that shows whether the market is overbought or oversold.

• A market that is overbought can refer to a market that has had a big move up in a short period of time. The higher the oscillator gets the more overbought it is. On the flip side, an oversold market occurs when the market takes a big move lower in a short amount of time and may indicate that we have overshot to the downside. In other words, investors may have gotten too negative and the market could be due for a bounce back.

The oscillator can show whether market levels have strong, weak or neutral averages. If the oscillator goes up to historical highs, we tend to get bearish (sell something). For example, if there is a huge market run in a short amount of time and the oscillator goes to a 7% or 8% reading, we have to find things to sell because historically this level is correlated to subsequent downturns.

• If a stock has rallied 20% in a week, that may be a good candidate to trim off and take some profit. This decision doesn’t necessarily relate to the quality of the company, rather it could be an ideal time for us to sell and raise cash, so we are ready to buy into another high-quality company that looks cheaper.

Currently, the oscillator is at an extreme overbought reading of positive 8%. We trimmed almost every single positions and also advised our clients to do so. We didn’t change our thesis on the companies, but we saw an opportunity to secure a profit after a very strong rally in a short period of time.

3. Is the position bigger than allocated?

This is the most straightforward consideration: when building and monitoring the portfolio, for each stock and sector, we have a strategic allocation of how many percentage of the portfolio we are willing to let the stock take up. We typically don’t like to let any particular stock position get much larger than the allocation. When we start to approach that level, we start to sell and take profits because there is always, always the possibility of the stock going down lower. The sell decision, in this case, is not a change of view on the company, rather it’s a risk management principle that any portfolio manager has to obey.

We decided to trim our position in Ford Motors Company (F) recently after the stock took off from $11 to $16 following its strong second-quarter earnings release. This strong move took the position to 13%, compared to the 10% we allocate for it. This was a discipline-over-conviction scenario because Ford had become the largest position in our portfolio. We are still as convicted as ever in Ford's business and stellar execution from CEO Jim Farley and team. However, we simply don't want our portfolio to be a Ford portfolio, that's why some selling is warranted. 

Last but not least, if the ugly bear market in the first half of 2022 didn't teach you anything, remember that there's always a possibility of lower prices. In May of 2021, Ford traded around the $11 level. In January of 2022, Ford traded up to $26/share, more than doubled. Who would have thought that just the same amount of time later, in June 2022, Ford came back to $11/share. Markets behave in cycles, there will be ups and downs.