How to Set Profit Targets
Knowing how to set profit targets is an essential part of successful stock trading. After all, it’s not the price where you get into a trade that determines your profitability – it’s the price where you get out of the trade. But, unfortunately, setting profit targets is a topic missing from many articles about trading that focus almost exclusively on identifying good trade entry points.
There are nearly as many strategies for setting profit targets as there are technical indicators. In the end, they’re all about support or resistance levels. Profit targets can, of course, be adjusted after entering a trade if the security’s price action leads you to believe that a profit target different from your original target is a more reasonable trade exit point.
In this article, we’ll give you what we think are four of the best methods of setting a profit target price. We’ll also explain why knowing how to set a profit target is so critically important to your trading profitability.
Understanding Why a Profit Target is Important
To put it bluntly, if you enter a trade without any idea of a profit target, then you’re flunking the money management/risk management part of trading. Say, for example, that you’re considering buying a stock because it’s at a price level that you think it might well move up from. Well, even if you’re right about that general idea, if you don’t have any idea about how far it might move up, then you don’t have a clear idea of whether taking the trade is a good idea or not.
What if, upon further examination, you determine that the stock may reasonably advance $2 in price. However, you think it’s also reasonable that, before going up $2 from its current price, the stock’s price action may take it down another $5. That’s a terrible risk reward ratio – you’re risking more than twice as much money as you hope to gain.
Having a great strategy for establishing a long position or short position is only half the battle. Having a great trade exit strategy is what will make you money. So, let’s help you find one.
A Day Trading Profit Target Strategy
One of the simplest methods of choosing a profit target when you’re day trading is using the average true range (ATR) – a technical indicator readily available with almost all charting programs. In the absence of significant fundamental news regarding a company – such as an important acquisition – or major changes in the price action of the overall stock market, most stocks tend to stay within their average daily trading ranges.
Therefore, the upper or lower limit of a stock’s average trading range defines a reasonable profit target price area. For example, assume that you buy into a stock that has an average range of $4 per day – and that your entry price is $1 above the current low of the day. In that instance, using the ATR to help you select a profit target, you might enter a take profit order to close out your trade a little below $3 above your entry price.
That way, even if the trading range for the stock on that day turns out to be only $3.50 to $3.75, your trade exit order will still close out your trade near the high of the day, giving you maximum profits on the trade.
Of course, if you’re trading from the short sell side, then you’d be looking to get in near the high of the day, with a trade close out order about $3.50 to $3.75 below that price level.
A Trailing Stop Profit Target Determines Your Exit
Swing traders or other longer-term traders may have a profit target in mind that’s well beyond a stock’s average daily trading range. Trading over a longer timeframe also makes it more likely that you may want to make several adjustments to your target profit level after entering a trade.
Many traders prefer to use a conditional order such as a trailing stop-loss order to make their exit from a market position. This is especially true when a trader has a profit target in mind and believes that the stock may advance much higher. The trader may use a trailing stop in hopes of obtaining greater gains if the stock does, indeed, continue advancing significantly above its initial profit target.
A trailing stop trade exit strategy also works well when your trade quickly shows a profit. Adjusting your initial stop-loss to a price above your trade entry price protects at least part of your profits (and, more importantly, ensures that your winning trade doesn’t turn into a losing trade).
Trailing stops are frequently placed using moving averages. For example, you might continually adjust your stop-loss order so that it’s just a bit below the 20-period moving average. That is, providing that you can see from previous price action that the 20-period moving average has been acting as a price support level. It may be the case that a different moving average line – such as a 10-period or 50-period MA – appears as a primary price support.
You can see in the weekly chart of Ford Motor Company stock (NYSE: F) below that a trader who bought the stock when it crossed over from below to above the 20-period moving average (orange line) could have safely ridden the ensuing uptrend a long way – while locking in a more and more profitable trade – with a trailing stop kept on the underside of that moving average.
A Pivot Point Profit Target
Daily pivot points are a technical indicator that many day traders employ to identify reasonable profit targets. Using pivot points is an alternative profit target strategy to using the average true range indicator, as the three resistance levels and three support levels shown with the daily pivot point define likely upper and lower trading range levels.
Some traders favor using pivot point targets simply because they’re aware that large numbers of traders base their buying or selling on the daily pivot points. Thus, pivot point levels acting as significant support or resistance may be something of a self-fulfilling prophecy. Because many traders expect buying support at pivot point support price, they buy at that price, effectively providing the price support that they expect to see.
Pivot points also provide an easy means of scaling your exit from a trade, a good money management practice. For example, say that you’ve purchased a stock right around the daily pivot point. You might then place three profit target orders – closing out one-third of your position at each of the three pivot resistance levels – R1, R2, and R3.
Round Number Profit Targets
Another easy method for determining a profit target is with the use of round numbers.
Examinations of historical price action of traded securities reveal that they appear to track toward the nearest round number level. For example, a stock that trades above $19.50 seems to be almost irresistibly drawn to at least touch the $20 level.
Because of such past price movement trends, some traders look to take profit on a trade at round numbers – such as $20 in the example above. Traders might also look for a stock that’s crested the $90 or $95 level to make it to $100.
Picking a Profit Target with Previous Support or Resistance
Profit targets are more likely to turn out to be good choices when the price level you identify for your trade exit is at or near a previously identified, significant price support or resistance level.
For example, suppose you’re considering a long position and looking to set your profit target in line with one of the three resistance levels identified by the daily pivot point indicator. Then you happen to notice that the R2 price level coincides with the weekly, monthly – or even yearly – high.
The fact that a previous periodic high has been a significant market reversal level, turning price back to the downside, is like an additional, confirming technical indicator that the stock’s price advance may be stopped at that price. Therefore, choosing the R2 price over the R3 as your take profit target puts the odds of closing your trade out with maximum gains more in your favor.
How to Set Profit Targets – Summary
As we said at the beginning, there are several different ways of selecting a profit target. The important thing is to have a clear idea of your potential profit and to make sure that your profit potential is greater than your trade risk. In other words, always trade with a favorable risk reward ratio – preferably, at least 2:1 or 3:1.
Keep in mind when looking for a good profit target that the essence of your search is trying to identify a price level where your stock is likely to encounter significant resistance (when you’re buying) or significant support (when you’re selling short).
Becoming skillful at selecting profit targets takes time and practice, just like any other trading skill. The longer you watch a stock trade, the more familiar you’ll become with how that specific stock tends to make price moves. Some stocks make volatile price moves; others are slow and steady. Some stocks usually advance in almost a straight line from one significant support/resistance level to the next, while others move in a more zig-zag fashion – up a little, down a little, up a little more.
Why is a profit target important?
Knowing how to identify a good profit target for a trade is an essential trading skill. You can only manage your trading risk effectively when you have a clear idea of profit potential versus how much you might potentially lose.
Are round numbers a good profit target?
Yes. Round numbers are good profit targets. Round numbers such as $10 or $100 act as a major level of support or resistance, and the psychological power of those price levels is immense. The profit target should be set a few cents before the round number to ensure that the sell order gets filled.