Last Updated on 29 June, 2022 by Samuelsson
If you have been trading the financial markets for a while, you would realize that trade management is a vital part of the trading process. Without trade management, you will not be able to make sustained growth, and a key factor in managing your trades is your ability to set a good profit target. But what is a profit target?
In the world of financial trading, a profit target is a level at which the profit is deemed to be enough. In other words, it is the point you choose, at the time of entering a trade, to exit from the trade if profitable. Your profit target determines the amount of money you intend to make in a trade. The profit target is an important part of order management, as it helps you to stick to your trading goals — if preset as a trade order, it automatically closes your trades even if you are not watching your trading screen at the time the target is reached.
In this post, you will learn the following:
- What is a profit target?
- How a profit target works
- Why you should set a profit target
- Strategies for setting a profit target
- Taking profit using a trailing stop
What is a profit target?
Also known as “take profit”, a profit target is that predetermined point at which a trader would want to exit his profitable trade to make an anticipated amount of profit. It is that level at which the profit is deemed to be enough for the risk taken.
Normally, when placing your trade order, you specify a price at which you will close your trade when it has made money. It is that price level you choose to exit from the trade if profitable that is known as a profit target. Your profit target determines the amount of money you intend to make in a trade. It is an important part of order management, as it helps you to stick to your trading goals.
You can set your profit target as an opposite trade order (a sell limit or buy limit order, depending on your trade type) at your chosen level when you place your trade entry, but some traders just mark the level and close their trades manually when the price reaches that level. If your profit target is a preset trade order, it automatically closes your trades even if you are not watching your trading screen at the time the target is reached.
A profit target can help a trader stick to their trading goals whatever they are. Both long-term investors and short-term technical traders use profit targets as a part of their strategies for managing risk. By creating a target price where they want to take a profit on a trade, traders use profit targets as a tool that reduces risk since the market doesn’t move in a particular direction forever — a profitable trade can turn to a loss if profit is not taken at the right time. But how exactly does profit target work?
How a profit target works
A profit target order is used to exit from a trade position, so it is an opposite trade order to the one the trade placed in the market. For instance, the profit target order for a long position is a sell order, while that of a short position is a buy order. So, the take profit order works by using an opposite order to keep you in a market-neutral position.
Interestingly, a profit target order is naturally a limit order, which means that when the market reaches the preset price level, the order is executed at that price or a better price. This is unlike a stop order that becomes a market order, which executes at any best possible price when the price level is reached.
There are different ways traders use profit targets. While some manually execute the order when the market reaches their chosen levels, others preset it at the time they enter their trade order. Whatever way a trader chooses, the trades are exited once the market reaches the expected level so as the secure the profits made.
So, the profit target tells a trader how much he stands to make if everything works as planned. It guides the trader in knowing how much reward he stands to gain from his troubles.
Why you should set a profit target
Profit targets can be seen as an essential part of trade management, which is very vital in managing risks. Without taking profits at the right time, it will be nearly impossible for a trader to be profitable because it serves as a guide to his reward/risk permutations.
The market doesn’t move in one direction forever; it can reverse at any time. The use of a profit target enables a trader to prevent the possibility of having a profitable trade turn into a loser. Hence, making use of a profit target strategy can help a trader to cash in on profits and prevent any potential for losses when the market changes direction.
Hence, while you may think that a profit target will always limit the potential profit of a trade, it inherently provides security because it ensures that you don’t hold a position for too long, only to see your running profit wiped out before you close your trade.
It may seem that the use of a profit target is against the popular trading adage: “Let your profit run.” But that is not true; a profit target allows you to get enough benefits for your risk while preventing you from letting a winning trade turn to a loss. So, you have to accept the fact that you can’t milk all the profits in a trade and be ready to take the profit you deserve. There is no need to regret if the market continues to move after exiting from your position.
Since the markets don’t move unilaterally but fluctuate, any profit can be lost every bit as quickly as they’re made. Experience in the financial markets shows that paper profit is not a real profit until the trade is closed, which is why many experienced traders use profit targets.
Different methods for setting a profit target
There are different ways traders set their profit targets when trading. These are some of them:
Using reward/risk ratio
Some traders set their profit target as a ratio of the risk they assumed in the trade. All things being equal, the risk refers to the size of their stop loss. So, they set their profit target at a multiple of their stop loss. The multiplying factor the trader uses depends on the quality of the trade signal and the expected price movement.
The most common practice is to use 2x or 3x the size of the stop loss. However, some can take just 1x or 1.5x the stop loss size, while other use as high as 10x the stop loss size.
Using the ATR
The ATR (average true range) is a volatility indicator that measures the range of price movement over a specified period. Most commonly, traders use a 20-period ATR to gauge the volatility in the market and use it to estimate where to safely place their stop loss.
While traders mostly use the ATR for estimating their stop loss position, some traders also use it to estimate their profit target. For this purpose, traders tend to use a multiple of the 20-period ATR. So, a swing trader who trades on the daily timeframe may decide to set his profit target at 2x the 20-day ATR.
Using the market structure
Many traders use one form of market structure or technical analysis tool to decipher a good position for their profit target. While there are many ways they can do this, let’s consider only the following:
It is common to find traders placing their stop-loss orders just beyond a nearby support or resistance level, as the case may be. In the same way, traders also place their profit targets just before a support or resistance level so they can exit from their position before the market potentially reverses.
For a long position, the profit target is placed just below a resistance level so that the trade is closed before the price can make a downward reversal. Similarly, when going short, traders do place their profit target just above a support level so as to get out of the position before the market can potentially make an upward reversal.
Fibonacci extension/expansion levels
Most trading platforms have Fibonacci tools. The Fibonacci retracement tool is used to show where a pullback can retrace before reversing, but the opposite end of it can be extended to project where the next price wave can get to. Some traders use these extension levels, especially the 123.6%, 138.2%, 161.8%, and 261.8%, to estimate their profit targets.
Unlike the retracement tool, the Fibonacci expansion tool is purely used to project where a price impulse wave can get to before starting a fresh pullback or an outright reversal. Thus, the expansion levels are natural levels for setting a profit target.
Projected price levels based on chart patterns
There are different types of chart patterns you can find in the market. Examples include the head and shoulder pattern or its inverse, the double top/bottom pattern, rising and falling wedges, triangles, rectangles, flags, and pennants. Traditionally, these patterns can be used to project a potential profit target when trading them.
For example, the profit target for a head and shoulder pattern is the height of the head measured from the neckline. This height is often projected to the opposite side of the neckline to get the profit target.
Some traders use their trading strategies to know where their profit target can be. This could be when the strategy gives an exit signal or a specific event in the market that tells the trader that it’s time to close their trade.
For example, when using a 200-day moving average to create a mean-reversion strategy, the trader may decide to exit his position when the price crosses the moving average line. Similarly, when using a 20-day high/low to trade mean reversion, the exit signal could be when the market makes a new 20-day low/high.
Using order flow signals
Big players, such as banks and institutions, often make use of order flow to decide the right place for their profit targets, and here’s why: Institutional traders often have access to level 2 market to see the order volume at each price level. Since they usually have huge orders, they need to target a price level where there are enough opposite orders to absorb their position.
Using volume profile
As with the order flow, some big players use volume profile to decide where to make their exit when they are in a profitable position. Volume profile is a charting technique that tries to estimate the volume traded at each price level. The higher the trading volume at a specific level for a longer time, the more likely the level will serve as support/resistance
So, reading volume profile charts can show you the areas where the price is likely to reverse, which are the levels you may want to place your profit target.
Taking partial profits using multiple profit targets
While you can close your trade position at once with one profit target, you can also scale out of the position by taking partial profits at different levels as the price progresses. This method allows you to capture maximum profits during long trends while making profits and minimizing the risk at the same time.
Taking profit using a trailing stop
Another effective technique for capturing more profits from a trending market is the use of a trailing stop. The trailing stop is a stop-loss order that is set to follow the price at a specified distance or percentage when it is moving in the direction of the trade, but when the price reverses, it stays at the same level to secure the already-captured profits.
Traders use this technique when the trend is very strong. However, it can be very tough to find the right distance away from the price. If it is too far away from the price, you give back too much profit, but if it is too close to the price, it can be taken out with minimal price fluctuation.