×

Cramer: Ouch! When to sell a hot stock

Jim Cramer is passionate about teaching investors to think like a Wall Street pro. That 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.

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 from Chipotle, to cloud stocks or even smaller biotech stocks.

Chicago Options Exchange
Joshua Lott | Getty Images
Chicago Options Exchange

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 formerly Monster 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 Cramer'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.

Questions for Cramer?
Call Cramer: 1-800-743-CNBC

Want to take a deep dive into Cramer's world? Hit him up!
Mad Money Twitter - Jim Cramer Twitter - Facebook - Instagram - Vine

Questions, comments, suggestions for the "Mad Money" website? madcap@cnbc.com