There are two very common approaches in trading: taking profits at a fixed target, or letting profits run (a trailing stop type approach). Both have merits and drawbacks.
Whether you decide to use a fixed profit target or let profits run, the most important thing is to actually use some sort of exit strategy. Breaking down what these methods are, along with their pros and cons, will help you choose the method that works best for your trading style, time frame and personality.
Be sure to also read about the 3 Ways to Exit a Profitable Trade.
Why the Exit Is Important, Yet Underappreciated
Many people spend loads of time searching for ideal entries, but it’s the exit that determines risk and profit. The entry is important, yet it’s only one piece of the trading puzzle (in addition to the exit, also consider position size).
You may get a great entry point, but if you can’t lock in profit the entry was wasted. An exit strategy attempts to remedy this. It dictates when the trader will take profit, forcing the trader to exit when an asset displays a specific set of conditions. Two common exit strategies are the fixed target approach, and the rather vague “let profits run” approach.
How to Use a Fixed Target
A fixed target takes profit at a specific price, determined at the outset of the trade based on the market conditions present at that time.
While the fixed target is an exit strategy, how it’s applied varies from trader to trader. If you buy a stock, you could place a fixed profit target right below an established technical resistance level. If you short-sell a stock you could place a fixed profit target right above an established support level. This approach is common when range trading or trading trend channels: buying near the bottom and selling near the top.
Be sure to also read our Beginner’s Guide to Trend Trading.
Charts courtesy of StockCharts.com.
Another fixed target method is the risk/reward approach. Many traders only take trades where they can make two, three, four (or more) times as much on their winning trades as they lose on their losers. When entering a trade a stop loss is placed. The distance between the entry and stop loss price determines the risk; assume it is $1 (per share).
If the trader uses a 5:1 reward to risk ratio, then a target is placed $5 from the entry point. If the target is hit, the trader makes $5; if the stop loss is hit the trader loses $1. With this approach the trader must ask “Is this target likely to get hit?” Using the support/resistance method mentioned prior helps traders determine this.
The benefit of the fixed target approach is that you’re going to lock in some profit on a regular basis. It is also useful for active traders, who don’t mind jumping in and out of the market, booking a profit (or loss) and then moving on to another trade. The downside is that you’re going to have very few “big” winners. You’re hitting singles and doubles consistently, but home runs are rare.
How to “Let Profits Run”
Letting profits run isn’t really a trading strategy until an actual exit method is implemented. How long do you let it run for? How do you know when it is no longer “running?” The easiest way to answer these questions is with a trailing stop. A trailing stop is an order that will get you out of a trade. If you own a stock, a trailing stop will rise as the price of the stock rises. Since the stock will eventually stop rising and reverse, the trailing stop locks in a profit. The amount of profit is determined by how far the price rose before reversing course and hitting the trailing stop order.
A trailing stop is implemented in a number of ways. One way is to set a stop loss, and set the order as a trailing stop. This is a “hands off approach” as the stop loss will move on its own with the price, not requiring you to manually move the stop. If a trailing stop is set to $1 (can be any amount) below the entry price, the trailing stop will always be $1 behind the highest price point reached. Once the stock falls $1 from the highest point the trailing stop will exit the trade for you.
Another approach is to use an indicator, such as a moving average or Chandelier Exits. Since these indicators move with the price, but trail behind, they can act as a trailing stop. If you’re long, the trade is held until the price drops below the indicator; when this occurs, exit the trade. This approach tends to work well in strongly trending markets, but poorly in sideways markets.
Learn more about How to Profit in a Sideways Market.
A manual trailing stop can also be implemented. If long a stock, each time the stock makes a new swing low, the stop loss is manually raised to just below the new swing low. That way, if the stock makes a lower swing low—a potential reversal signal—the trade will be stopped out (see: 3 Ways to Exit a Profitable Trade).
The benefit of the let profits run approach is that when a big trend develops, you stand to make a lot. When strong trends are present this strategy is useful for traders who don’t want to be active. Unfortunately, when the market is choppy, this method can result in lots of trades because the price keeps reversing and closing you out of the trade. With this approach, you will eventually a hit a few home runs (big winning trades) but when a strong trend isn’t present you are going to take lots of small losses and profits.
Which Trading Strategy Suits You?
Based on the Pros and cons of each strategy, one likely appeals to you more than the other. Both strategies take work. With the ‘let profits run’ method you must adjust your stop price as the price moves in your favor (this can be automated in many cases). Also, trades that fail to trend will be stopped out quickly, meaning another trade needs to be found.
Profit target traders may be in and out of the market more often, but are booking profits (and losses) likely on a more regular basis. Letting profits run can be psychologically difficult, as some profit is always given up at the end of the move. Profit targets may get a trader out right near the end of the move, but sometimes the trader leaves a lot of money on the table by taking profits.
There is no right or wrong here. Which one are you most comfortable with? Pick one and stick with it. Also consider using both: place a fixed target, and as the price is moving towards it, implement a trailing stop.
The Bottom Line
One strategy isn’t necessarily better than the other. Ultimately, which strategy is better is the one that works for the individual. Letting profits run could mean more losing trades waiting for that big winner, but the winners can be huge when they come. Fixed targets are based on the tendency of the market being traded, therefore, the win-rate is typically higher so profits are booked more often. Under this strategy though there are almost never “home run” trades.
All in all, establishing an exit method is key to successful trading. Find and implement a method, and stick to it.