For every trade you take, you have to exit at some point. The difficult part of trading is deciding when and how to exit or sell a position; it is easier to know when to enter a trade than when to exit it. This is why your trading plan must specify your profit taking strategy. But, what is a profit taking strategy?
A profit taking strategy defines how and when you will close your open positions to realize a profit. There is a variety of profit-taking strategies to achieve this result. Some traders liquidate their position all at once, while others look for opportunities to liquidate their position in stages (scaling out) as the market moves in their favor. Setting a profit target could be based on technical analysis or a fixed dollar value that achieves the desired reward/risk ratio.
We also remind you that we have written hundreds of other robust trading systems.
In this post, we take a look at the strategies for taking a profit. We end the article by showing you a backtest of a profit taking strategy.
What is a profit taking strategy?
A profit taking strategy refers to how you will close your open positions to achieve maximum profits from the trades.
There is a variety of profit-taking strategies to achieve this result. Some traders liquidate their position all at once, while others look for opportunities to liquidate their position in stages (scaling out) as the market moves in their favor.
When setting a profit target, some set their profit targets based on technical analysis, while others use a fixed dollar value that achieves their desired reward/risk ratio. There are also traders, like George Soros, who go with their gut instinct.
To arrive at an appropriate exit strategy for you, you must first understand your overall trading strategy and the type of trader you are. The ideal thing is to have a well-defined strategy and trading plan, which specify your entry point, potentially a stop loss (which normally makes the system worse), and take profit levels. These must have been confirmed through backtesting to offer the best results.
We STRONGLY recommend you start backtesting if you are not doing it already:
Profit taking strategy (different methods)
There is no such thing as a “best exit strategy” in trading, so the only rule to follow is “keep it as simple as possible.” The more variables you include in your exit strategy, the more likely it is that your backtests will curve fit (what is curve fitting in trading?).
There are several methods for getting out of a trade. There are numerous ways to close an open position in trading. Some of the most effective methods for taking profits are as follows:
1. Time-based exit
This is one of the most straightforward ways out of the trading position. You leave after a predetermined period, which could be minutes, days, months, or bars. Because it isn’t overly complicated, a time-based exit is one of the most effective exits you can use.
From experience, one advantage of using a time-based exit strategy is reduced drawdown. An exit like this ensures that you only stay in the market for a short period and allows you to exit the market early if a bear market is starting.
Another advantage of using a time-based exit is that it eliminates the need for curve fitting. There are probably more productive things you could be doing with your time than optimizing the exit, and exits based on time are not only simple but also highly effective. By backtesting exits between 10-25 days (for example) you quickly find out if the exits is sound or erratic.
2. Using opposite signal
You can exit a position using the opposite signal to the one you used when entering a position. For example, if you enter a long trade based on bullish divergence in stochastic, you can exit the position when an opposite signal — bearish divergence — occurs.
Divergence is one of the most reliable signals you can get when trading any type of instrument. And, it can occur in both the bullish and bearish directions, so it is a good way to exit a position if used to enter a position.
3. Using trailing stops
This is a common strategy used by trend-followers to lock in profit as the market moves in their favor. A trailing stop is a dynamic stop loss order that trails the price as it moves in your favor. It moves along with the price when it is moving in your favor but stops and stays at the last level it got to when the price moves against your position — this way, it locks in the profits.
There are different methods of trailing profit. A trailing stop can be set at a percentage of the profit or a fixed amount away from the profit.
But some indicators have been found useful for trailing profit. One of them is the moving average. Many trend followers use a moving average indicator or a moving-average-based indicator like the Donchian channel. Another common indicator for trailing profit is the ATR, which measures volatility. Some traders trail their profit one or two ATRs away. There are those who use fractals — moving their stop loss to the next swing low/high from the current price level.
4. Using a fixed profit target
Another exit strategy is establishing a profit target. This could be based on support and resistance levels. For example, if you come across a currency pair, index, or commodity that is trading in a narrow range, you might want to take advantage of the movement by buying the weakness at the bottom of the range and selling the strength at the top.
Some traders use a fixed dollar value that achieves their desired reward/risk ratio.
5. Fundamental exits
Sometimes it is in your best interest to exit your position whenever there is important news in the financial markets that can cause an economic shock. Numerous fundamental news events could be very significant. For example, after Donald Trump was declared the presidential election winner on November 8, 2016, the Dow Jones Industrial Average increased by 9,100 points in less than a year. If you were bearish on the index before the news, exiting your position as soon as possible would have been a wise decision.
6. Exiting based on instincts
We don’t recommend this at all. But there are a few exceptional traders who are “in the zone” and seem to feel the flow of market movement. Their gut feelings tell them the best time to exit their positions. George Soros once remarked that he exits mostly based on his gut feeling.
What is the best way to take profits from a trade?
No one method of profit generation is inherently superior to the others. Your trading strategy and plan will ultimately determine the outcome. Backtesting your strategy is important if you want to know which strategy will work best for you in the long run.
Taking profits vs. holding
Developing a strategy for how long to keep or sell a stock is very important. Before buying or selling an asset, you need to think carefully about several things, such as how much risk you are willing to take and how soon you will need the money. In other words, you should have a financial plan that lays out your short-term and long-term financial and investment goals.
It can be not easy to decide whether to hold on to a stock or sell it. No strategy is guaranteed to be successful in every situation regarding selling stocks. Instead, you determine that from your investment strategy, which is influenced by various factors such as risk tolerance, tax rate, time horizon, and financial objectives. The following are some of the factors that determine profit taking and holding of investments.
When you close a trade within a year, which is considered short-term trading, you are subject to higher tax rates (up to 30%), and any profits you make must be taxed. This cuts down on the amount of money you have to put into the next trade, which slows the rate at which your profits grow.
You should set a time horizon before purchasing stocks or making any other investment. If you have a long-term time horizon, you are more likely to be able to weather market corrections or downturns. If, on the other hand, you need the funds in a relatively short period, say, within the next one to two years, you may be better off using a short-term trading strategy rather than holding.
Risk tolerance refers to the amount of exposure to the potential loss that an investor is willing to accept with each investment. Some investors are willing to take on more risk in exchange for a higher rate of return, even if this means missing out on new opportunities.
If you are willing to take on more risk you may be more likely to invest in equities, such as an index fund that tracks the S&P 500, and hold for a long time.
It is crucial you have a clear understanding of your risk tolerance before deciding to play in the financial markets. This would help you develop a suitable investment strategy. Your strategy must consider factors such as the types of stocks to buy, the proportion of your portfolio that should be invested in stocks versus bonds, and the best times to buy, sell, and hold their investments.
You may decide to be a short-term trader simply because you don’t want your money to stay in the market for a long time and also want to use stop loss to limit your potential losses. On the other hand, if you can stomach bear markets and deep market corrections that can wipe out up to 30% or more of your invested capital, you may want to try out buy and hold. In that case, you choose stocks that have long-term potential based on their fundamentals and not on market timing.
Profit taking strategy crypto
Numerous trading opportunities exist in the crypto market, given its high volatility. Even though there is no foolproof way to time the market and know when to cash in on crypto profits, get out of the market, or stay invested, there are a few strategies and tips you can use to lock in on your profits. These are some of them:
1. Setting profit targets
Depending on your crypto profit-taking strategy, the profit target can be either a specific price target or a percentage-based target. The trade can be manually or automatically closed when the price reaches that target. If you set a take profit order with the broker or exchange, the trade would be automatically closed at that point, but if it is just a mental target, you would have to close the trade manually when the price reaches the desired level.
For example, if you bought Bitcoin for $31,710 and your desired rate of return is 2%, you would place an order to sell it at $32,344. The trade will be terminated when the price of Bitcoin reaches the predetermined threshold.
2. Using technical analysis to know when to exit
Many traders use technical analysis to figure out when to get into and get out of a market to make the most money and take the least amount of risk. A common example is determining support and resistance levels. If you examine the price chart of any cryptocurrency over almost any period, you will notice areas where the price appears to stall after moving upward for a while. These are referred to as “resistance areas.” On the other hand, areas where downward momentum is halted are called support areas.
Depending on the direction you are trading, you can set your profit target at a resistance level or a support level. If you are long, you set your profit target at a resistance level, and if you are short, you set it at the support level. You can also use the Fibonacci extension/expansion tool to anticipate future resistance or support levels for your profit target.
See the EURUSD chart below:
Let’s say, as a swing trader, you decided to trade the downward channel in the EURUSD chart above. Your entry signal was to go short when the price touches the upper border of the channel and the RSI gives an overbought signal. See the white arrows.
Using an opposite signal exit method, you close your trade when the price reaches the lower border of the channel and the RSI gives an oversold signal. See the green arrows.
Profit taking strategy backtest
We have backtested and traded quantitatively for over two decades, and our conclusion is simple: A stop loss and/or a profit target makes the strategy worse (as a rule of thumb). Please read our take on the best stop loss strategy.
When we backtest the strategy on Nasdaq 100 (QQQ) we get the following equity curve:
The average gain is 1.8% per trade, and you can see that the drawdowns are short and relatively small. In other words, a good strategy!
The strategy has a simple exit variable and no profit target.
Let’s investigate hos the strategy performs when we use a profit target. The table below shows the results when we use a percentage profit target that exits precisely on the target. We use a profit target ranging from 1 to 10%:
|Avg per trade %||End result in millions||Max drawdown %|
|No profit target||1.89||1.317||19.5|
|1% profit target||0.89||0.41||13.4|
|2% profit target||1.23||0.583||13.4|
|3% profit target||1.48||0.815||13.4|
|4% profit target||1.54||0.821||19.5|
|5% profit target||1.6||0.854||19.5|
|6% profit target||1.69||0.983||19.5|
|7% profit target||1.76||1.094||19.5|
|8% profit target||1.79||1.145||19.5|
|9% profit target||1.85||1.246||19.5|
|10% profit target||1.83||1.198||19.5|
Not a single profit target improves the results!
Of course, we might get other results for another strategy. However, as we indicated earlier in the article, a profit target usually limits the upside.
Limiting the upside doesn’t make much sense to us. Why limit the upside? You don’t know how far a strategy can go! As the saying goes, let the profits run.
Profit taking strategy – conclusion
Many traders like to use both a stop loss and profit target, but the great majority of strategies perform worse with one or both included.
There is a much better alternative to a profit target. Trade many strategies that have different time frames, trades both long and short, and involve many different assets.