How I Set Profit Targets

11/23/2009 10:35 am EST

Focus: STRATEGIES

When talking about trading the financial markets, including currencies, "system" is almost always taking central stage. By "system" I mean a set of rules that dictate when a trader gets into the market, irrespective whether it is a short or long position.  A lot of energy is devoted to finding the perfect strategy, in most cases focusing on entry rules. Unfortunately, no trading method consists only of getting into the market. There are other elements that must be carefully incorporated into a system, such as money management, stop loss and target exits, objectives, and setting rules. It is really amazing how many people overlook one or more of these variables, thereby creating incomplete trading plans.

Everybody knows why stop losses are important, even though a lot of us ignore this obvious knowledge in real life trading. But exit targets are also important, if not instrumental, to trading success. Since markets are in constant motion, we should always know how far we expect them to move our way and try to take profit at predetermined point. Not that it will always happen the way we want, of course, but we must have a plan in place, rather than getting into position and hoping to close the trade sometime in the future.

How exactly do we go about setting targets for our trades? There is no one simple answer, and there are many methods of choosing objectives in existence.  But in almost all cases exit strategies are directly dependent on entry systems: 

  • A fixed number of pips or points
  • Time-based exits such as closing trades at predetermined times, like the end of a session, end of the day, week, or some other variation
  • Using previous resistance and support areas
  • Simply staying in trades for as long as a trailing stop keeps positions active
  • Using a technical tool like parabolic stop and reverse
  • Employing technical indicators to determine oversold/overbought levels at which to close trades
  • Using crossover strategies such as moving averages, or MACD

In all of these cases, back testing provides some evidence of what can be expected.

Most of my trades are discretionary and swing trades. This is nothing more than analysis of most recent price swings. In very simple terms, "swing" is a distance price covers between the high and low (or low and high, depending on point of view). Those highs and lows are also "pivot points" for price movements. Most recent swings are used as a tool to set targets for next moves.

Below is a simplified example of a price swing. Movement from point A to B is a swing, with either one being a pivot point when price moves to the other side.

chart
Click to Enlarge

The example above is, of course, a price reversal.  After a downtrend, the move is running out of steam and will be changing direction. Going above the most recent high (A) creates a buy situation with A becoming a pivot point.

|pagebreak|

chart
Click to Enlarge

According to simplified swing trading theory, once a pivot point is established, and in this case, it is a minor high (A), price should move higher the same distance it travelled before the reversal happened. In other words, the distance between A and B, in the latest down swing, is the same distance by which price should move above the pivot point. This gives us a projected target at C. Swing theory relies heavily on symmetry on the markets, not exact, but general.

One important note here is that even though the distance from A to B indicates magnitude of probable swing above our pivot point, it really doesn't say anything about how price is it going to get there. Will it be a straight move or a serious of smaller pulses and swings? (See the chart below)

chart
Click to Enlarge

For our purposes, we focus on the fact that once price moves above A, it should reach objective C rather than going down to B. If that should that happen, however, the breakout is a failure, and we could use B as a new pivot point for a move down.

Some people might be surprised that any one single swing can provide a framework for price projection. However, anyone who has even rudimentary knowledge or interest in technical analysis will have come across projections done from more complex price patterns. Head and shoulders patterns, cup with handle, saucer, rectangle, triangles, and just about any other formation provides guidelines for how large the move should be once price moves outside of the pattern.

chart
Click to Enlarge

If you look closely, it should be noticed that it is not formation itself, but the largest price swing within it. The above example should make it clear. Any single swing provides the price objective for the next move.  This is setting trading objectives using swing trading theory in its simplest form.

NEXT: Case Study Using Recent NZD/CAD Trade

|pagebreak|

Here is a chart of very recent trade set up that happened on a four-hour chart of NZD/CAD.

chart
Click to Enlarge

Price was moving down, reaching about the 0.07630 level, before starting to turn around. At this point, I estimated that chances for a reversal were high enough to start planning a long trade. The most recent high was 0.7750 (A), which would become a pivot point, as well as my entry for a buy.  In accordance with my rules outlined earlier, after moving above the pivot point, one could expect price to proceed for about 120 pips, or roughly 0.7865. This calculation can be done manually, but most charting and trading platforms provide a Fibonacci tool.

chart
Click to Enlarge

Here it is in use above. The 200% Fibonacci level marks the profit target. We can see that the objective for the move up coincides with the previous high at 0.7865. This is important because resistance should be expected at this level, providing an additional reason to exit and take profits.

Finding additional reasons for the exit near the objective is often helpful. These could be running into dynamic support or resistance (moving averages or trend lines) or simply round numbers where other traders have placed stop or buy orders. Another way I improve my probabilities of success is lowering the value of projection, making the target a little smaller. After all, it is easier for price to move ten pips than, say, 100 pips. Not to mention faster. Question is, just how much smaller do we want to make our targets in order to increase the odds, but without passing on too much opportunity? Just like everything in trading, it demands reaching certain balance, which is achieved through compromise of some sort.

In the example below, I use a target of about two-thirds of my projected target for my objective.

chart
Click to Enlarge

It is still a large enough chunk of my original projection and should be reached much faster and with higher degree of probability.

It is very easy to calculate using the same Fibonacci tool with 1.618 (1.62) setting. I still look for combination of additional reasons to close the trade at that level, as explained earlier.

The chart above shows that this modified, yet more likely, objective would be around 0.7820.

MORE: See How This Trade Ultimately Played Out

|pagebreak|

The chart below shows how price progressed from the point of analysis.

chart
Click to Enlarge

The move indeed occurred as expected and traveled through the entry level and reached both projected prices. I took profits at 0.7820, the lower target. The NZD/CHF currency pair is currently setting another potential buy signal, where these same rules can be applied.

The chart below is compressed to include more price history.

chart
Click to Enlarge

After making a high at 0.7890, price fell to 0.7690 before making another run. Currently, a move above 0.7900 might be a very tempting buy. Now, I don't know if this will happen, or if I would take the trade. It depends on how active I'd be at the time. However, the target for this trade would be at 0.8000. This is not only the 1.62 Fibonacci level, but also marks a level of previous resistance and a round number.

Most of my trades are not created by a rigid, inflexible system. This means that setting and waiting for targets also have elements of discretion. Sometimes I don't wait until an objective is achieved. Emergence of an ominous candlestick pattern, for example, can also be a reason to close the position before the target is met. On the other hand, if move is especially strong and fast, I can decide to extend the objective and employ a trailing stop. But for the most part, I stick to the rules outlined here.

By Mike P. Kulej, trader and blogger, FXMadness.com

Related Articles on STRATEGIES