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Easy Formula for Setting Profit Targets
06/14/2012 2:00 pm EST
Using the "Trader’s Equation," it’s possible not only to filter out lower-probability trades, says Al Brooks, but it’s also easier to determine where a proper profit target should be set.
When you buy above a signal bar, what is your first profit target? We’re here to find out with Al Brooks.
When I am buying, I am always thinking in terms of the Trader’s Equation. I am always thinking in terms of mathematics, and I want the probability of success times the reward that I stand to make to be greater than the probability of failure times the loss should the trade go against me.
If I look at a trade and I think that it’s a really strong buy set-up, like a pullback in a bull trend, I am confident that there is at least a 60% chance that I will be right.
For the Trader’s Equation to be profitable, I need a profit target that is at least as large as my risk, so if the bar is $0.20 tall, my risk is one tick above where I went long to one tick below where my stop is, $0.22. I will try to use a profit target that is about $0.22, maybe $0.20, maybe $0.25.
On the other hand, if I am buying in a situation where I am not as confident about the probability—let’s say in a trading range where the probability might be 50/50—if I am risking $0.20, mathematically, if I go for a $0.20 scalp, I will lose money.
If you do the mathematics on the Trader’s Equation, if the probability is only 50%, you almost always have to go for a profit target that is at least twice the size of your risk, so if I am uncertain about the set-up and I buy and am risking $0.20, I will only take that trade if I am willing to hold the trade for a 40% profit, because anything less than that, if I take 100 of those trades, I will lose money.
For very strong trades, I always go for a reward that is at least the size of my risk; for less-strong trades, I want a reward that is at least twice as large as my risk; and in pretty much no case should traders be taking trades where the risk is greater than the reward because then you have to be right 80% or 90% of the time. That’s very difficult to do, even for a very experienced trader.
Sure, and this works across the board? This is a secular system that you’re talking about where you can use this with individual stocks or you can use it with indices or even the E-minis?
Right, absolutely. It’s mathematical and it’s just basic trade management. It applies to any type of trade that you do in any market and on any time frame.
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