One of the biggest debates I have with day traders is over whether to take profit targets or to use a trailing stop. While I prefer to “let my winners run,” other traders may choose to take predetermined profit targets. Let’s keep in mind that a profit is a profit, so there’s no wrong way to take yours. That said, there’s a difference in opinion when it comes to how to take them.
First, let’s go ahead and discuss taking a predetermined profit target. The first questions to ask ourselves here are centered around how a trader chooses a target in the first place. Is it better to place your targets based on risk-reward ratio (say 2:1, for example), or would you be better off placing profit targets based on the probability of where price may be more likely to go?
All too often I speak with traders who insist on a profit model based on rigid profit targets— a good example of this type of targeting strategy is having a 20-tick stop-loss with a 100-tick profit target. While the reward-to-risk ratio is fine (5:1), what if the market isn’t willing to give you a full 100 ticks in profit? Or, even worse, what if you’re leaving money on the table? I suggest that traders identify a realistic profit target.
So, what’s a realistic profit target anyway? Personally, if you’re going to use predetermined profit targets, I’d recommend setting them so they’re not only realistic, but also logical. Some great ways to set profit targets are to use resources such as Fibonacci extensions, targeting support or resistance levels, and even previous highs, lows, and/or pivot points. Check out the chart below and you’ll see what I mean.
What I’m demonstrating here is the use of recent pivots, along with a support line and resistance line for realistic, higher-probability profit targets. For example, it would make sense for price to travel from our entry point to the recent pivots before possibly pulling back, or even changing direction. In this case, the price for the S&P 500 blows right past all the recent pivot highs and continues all the way up to a significant resistance level, which is another great way to choose a profit target.
So, I’ve shown you how to take profits with predetermined targets and we did well. Now, let’s use the ES chart and try a trailing stop method to see if we can do any better. For the next example, we’ll try some of the recent pivot lows— I’ll use the same chart and timeframe, as well.
You can see from the chart above that we did well, but not as well as we did when using the previous highs as targets. Is trailing the stop worse than targeting previous pivot highs? Not necessarily: after all, if we didn’t get that pullback that fell below the third pivot low, the market could’ve continued to run to the upside! As we all know, markets can’t continue in the same direction forever.
For the last example I’m going to use the same chart, but this time use moving averages to trail the stop. Let’s see how we do.
While using exponential moving averages (EMAs) still netted a profit, they didn’t perform as well as the previous pivot highs we used as targets, nor as well as the recent pivot lows we used to trail the stop. While the EMAs still “took us out” with a profit, it’s been my experience that using any type of moving average for a trailing stop will perform better in a stronger, trending market.
As you can see, there’s no wrong way to take your profits, as long as you choose a method that works with your style and provides a profitability ratio that keeps you in the game.