How to Set Your Stop Loss and Take Profit

Why Trade With a Profit Target?

Establishing where to get out before a trade even takes place allows a risk/reward ratio to be calculated on the trade. Just as important as the profit target is the stop loss. The stop-loss determines the potential loss on a trade, while the profit target determines the potential profit. Ideally, the reward potential should outweigh the risk.

While we can never know which trades will be winners and which will be losers before we take them, over many trades we are more likely to see an overall profit if our winning trades are bigger than our losing trades. If day trading forex and our winning trades average 11 pips while our losing trades average 6 pips, we only need to win about 40% of our trades in order to a produce an overall profit.

By trading with a profit target, it is possible to assess whether a trade is worth taking. If the profit potential doesn't outweigh the risk, avoid taking the trade. In this way, establishing a profit target actually helps to filter out poor trades.

Pros and Cons of Profit Targets

There several benefits to trading with a profit target, some of which were briefly addressed above, but there are also some drawbacks to using them.

The positive aspects of using profit targets include:

• By placing a stop loss and a profit target, the risk/reward of the trade is known before the trade is even placed. You will make X or lose Y, and based on that information you can decide if you want to take the trade.
• Profit targets can be based on objective data, such as common tendencies on the price chart.
• Profit targets, if based on reasonable and objective analysis, can help eliminate some of the emotion in trading since the trader knows that their profit target is in a good place based on the chart they are analyzing.
• If the profit target is reached, the trader capitalized on a move they forecasted and will have a reasonable profit on the trade. Assuming the trader was happy with the risk/reward of the trade prior to taking it, they should be happy with the result regardless of whether they win or lose. In either case, they took the trade because there was more upside potential than downside risk.

There are some potentially negative aspects of using profit targets as well:

• Placing profit targets requires skill; they should not be randomly placed based on hope (too far away) or fear (too close). This is addressed in the next section.
• Profit targets may not be reached. The price may move toward the profit target but then reverse course, hitting the stop loss instead. As mentioned, placing profit targets requires skill. If profit targets are routinely placed too far away, then you likely won't win many trades. If they are placed too close, you won't be compensated for the risk you are taking.
• Profit targets may be greatly exceeded. When a profit target is placed, further profit (beyond the profit target price) is forfeited. If you buy a stock at $6.50 and place a profit target at $6.60, you give up all profit above $6.60. Remember though, you can always get back in and take another trade if the price continues to move in the direction you expect.

Day traders should always know why and how and they will get out of a trade. Whether a trader uses a profit target to do this is a personal choice.

Fixed Reward:Risk Profit Targets

One of the simplest tactics for establishing a profit target is to use a fixed reward:risk ratio. Based on your entry point, it will require your stop loss level. This stop loss will determine how much you are risking on the trade. The profit target is set at a multiple of this, for example, 2:1.

If you enter a short trade at $17.15 and determine your stop loss should be placed at $17.25, you are risking $0.10/share. If you opt to use a 2:1 reward:risk, then your profit target would be placed $0.20 from your entry, at $16.95.

If you buy a forex pair at 1.2516 and place a stop loss at 1.2510, you are risking 6 pips on the trade. If using a 2.5:1 reward to risk, your profit target should be placed 15 pips from your entry point (6 pips x 2.5), at 1.2531.

Fixed targets assure you are making more on winners than you lose on losers, but fixed targets don't factor in the current price environment or tendencies within the price action. This makes fixed targets somewhat random. Although, if you have a good entry method and your stop loss is well placed, then it is a viable method.

Typical reward:risk ratios are between 1.5:1 and 3:1 when day trading. Experiment (in a demo account) with the market you are trading to see if a 1.5:1 reward to risk or a 2:1 reward to risk ratio works better for your particular entry strategy.

Measured Move Profit Targets

Chart patterns, when they occur, can be used to estimate how far the price could move once the price moves out of the pattern. For example, if a stock forms an intraday range between $59.25 and $59.50, that is a $0.25 range. If the price moves above $59.50 or below $59.25, another move of $0.25 could reasonably be expected (up to $59.75 or down to $59).

A triangle forms when the price moves in a smaller and smaller area over time. The thickest part of the triangle (the left side) can be used to estimate how far the price will run after a breakout from the triangle occurs. Triangles are covered extensively in Triangle Chart Patterns and Day Trading Strategies.

If the price moves aggressively higher, say jumping $1 in price, and then stalls, moving in a narrow range for a few minutes of say $0.06, when the price breaks out of that consolidation it could well move about $1 again (either higher or lower). This is referred to as a Trade Flag Pattern.

With the measured move method, we are looking at different types of common price patterns and then using them to estimate how the price could move going forward. Measured moves are just estimates. The price may not move as far as expected, or it could move much further.

Measured moves provide a way to estimate a risk/reward ratio. Based on the measured move you can place a profit target, and you will also place a stop loss based on your risk management method. The profit potential should outweigh the risk. If the expected profit doesn't compensate you for the risk you are taking, skip the trade.

Market Tendency and Price Action Analysis Profit Targets

Market tendency and price analysis require the most research and work. The benefit is consistent performance if the trader can properly identify the market tendencies.

All intraday price moves can be measured and quantified. Prices have certain tendencies; these tendencies will vary based on the market being traded. A tendency doesn't mean the price always moves in that particular way, just that more often than not it does.

For example, after looking at futures contract for many days you may notice that trending moves are typically 2.5 to 3 points, and those moves are typically followed by 1.0 to 1.75 point corrections. After the price has pulled back 1.0 to 1.75 points, it then trends another 2.5 to 3 points. Depending on the entry point, you can use this tendency to place a profit target. If going long in an uptrend like this, your target should be less than 2.5 points above the pullback low. Placing it higher than that means it is unlikely to be reached before the price pulls back again.

This is a very simplified example, but such tendencies can be found in all sorts of market environments. Place your profit target based on the tendencies that you find.

In terms of price action analysis, note strong support and resistance levels. Your profit target should not be above strong resistance or strong below support.

For example, if there is resistance at $5.25 but one of the aforementioned methods tells you to buy and place a profit target at $5.30, you may wish to skip that trade or revise your target to $5.24 (if the trade is still worthwhile). If you are long, you are better off getting out just below resistance. You can always get back into another trade if the price keeps moving above resistance. Same with support. If your target based on the aforementioned methods is well below support, consider skipping that trade. Alternatively, get out near support (if the reward:risk is still favorable); you can always get back in if the price continues to move below support.

Final Word on Profit Targets

There are multiple ways profits targets can be established. When you use a profit target you are estimating how far the price will move and assuring that your profit potential outweighs your risk.

Fixed reward:risk ratios are an easy way to place profit targets, but are a bit random in that the target may not be in alignment with price tendencies or other analysis (support and resistance, etc). The upshot is that it is an easy method to implement and you always know your winning trades will be bigger than your losing trades. Adjust the fixed reward:risk ratio as you gain experience. If you notice that the price typically moves past your 2:1 fixed target, then bump it up to 2.2:1 or 2.5:1, for example.

Measuring moves is a valuable skill to have, as it gives you an estimate of how far prices could move based on patterns you are seeing now.

Researching market tendencies can be tedious work,  cataloging loads of price moves over many days (weeks and months), but it can provide tremendous insight into how a particular asset moves. These tendencies won't repeat every day in the exact same way but will provide general guidance on where to place profit targets.

When starting out, the fixed reward:risk method works well. Use a 1.5 or 2:1 reward to risk, and see it how it works out. If the price isn't hitting your target, reduce the target slightly (on all your trades). If the price is running well past your targets, then increase the target slightly (on all your trades). As you become more experienced, fine-tune your profit targets based on the other methods provided, if needed.

How to Set Your Stop Loss and Take Profit

Source: https://www.thebalance.com/where-to-take-profit-when-day-trading-exit-strategy-4117900

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