Cramer: Hot tamale! When to sell a hot stock

Jim Cramer is passionate about not just providing Cramerica with a list of stocks to buy but also educating investors on running their portfolios like a pro. This means arming them with enough tools to know when the time is right to make big moves with stocks.

“I want to talk about selling, which, along with when you buy, may be the most important and undervalued tool in your home arsenal,” said the “Mad Money” host.

So, how do you know when to sell a hot stock?

Just like when you attend a party, you have to know when it is the right time to leave. When dealing with stocks, there is a lot of money to be made by owning a hot stock with a lot of momentum. The trick to making the most money is to know when it’s time to get out.

In Cramer’s experience, there will always be naysayers for a stock. Ultimately, the naysayers will usually be proven right, and that means hot stocks will implode. Cramer saw this happen in stocks ranging fromChipotle, to cloud stocks or even smaller biotech stocks.

When Cramer refers to a hot stock, he means hot speculative stocks. Those are stocks of companies that have a low market capitalization and have very little research coverage from major Wall Street research houses. Sometimes, these stocks can catch fire and stay hot for years.

“The key to figuring out when interest has peaked and it is time to sell is by watching the analyst coverage,” Cramer added. (Tweet This)

A trick that Cramer uses is that once a hot stock has at least six analysts covering it, then the love may die down for the stock. That’s because it is about to be too big and too well known, and the stock cools off when everyone who was interested in buying it has already done so.

“This formula has worked for me as long as I can remember. As far as I can tell, it works because the number of analysts on a stock is a good gauge of how much awareness and interest there is in a name,” Cramer said.

One example of this was with Hansen Natural, which was formerlyMonster Beverage and the hottest stock of 2004. Cramer called the top on this one in 2006 when it picked up its fourth analyst, and then announced a five-for-one split that brought even more interest to the stock. The combination of these two was enough for Cramer to see flashing red “sell” signals.

In the “Mad Money” host’s opinion, it’s better to get out of a stock early than to wait for your profits to fade away. Hansen was a good representation of what can happen with a hot stock. Once it hit the critical mass of analyst coverage, all profits faded from there.