Last Updated on July 21, 2021 by Oddmund Groette
Many traders use various forms of stops in their trading. One of them is the profit target. A profit target is exactly what the name says: a pre-set price where the trader takes profits and exits the trade/position.
Many traders use a profit target, but that does not mean it’s a rational target to use. Should you use profit target in your trading strategy? Our conclusion is pretty straightforward: Most of the time you should not use a profit target because we find very little empirical research that justifies a profit target. As a matter of fact, we believe they complicate trading strategies and make them more prone to curve fitting. Thus, be very careful of using profit targets in your trading strategy.
In this article, we provide examples of how the profit target changes the overall result of a trading strategy. Even if a profit target improves the strategy, it doesn’t mean you should use one. We explain why in the examples we provide.
However, our conclusion is based on general terms. There are no clear-cut answers in trading, luckily, but we suggest you test many strategies yourself before you draw your own conclusions.
What is a profit target in trading?
It means exactly what it says:
A profit target in trading is having a limit when you sell or exit your position (you cover if you are short) to realize a gain or profit.
Normally, this is a predetermined price level where you will exit at a profit. We emphasize the word profits: we are not talking about stop-losses which is something completely different.
It could also be a moving target, but most traders use an already pre-determined level before they enter the trade.
Why use a profit target in trading?
Why do traders use profit targets?
The main reason, we suspect, is that it’s painful to see a profitable position turn to a smaller gain or perhaps even to a loss.
Let’s face it, many traders let their bankroll decide their actions, not the math or the probabilities. Trading is a psychological game much more than a numbers game (for most traders). Good traders keep detachment from their bankrolls.
Another reason might be money management. For example, you have tested a portfolio of, for example, 20 trading strategies, and your overall performance improves because of different opportunity costs. Profit targets can, in practice, be used for efficient capital allocation between strategies.
Another reason could simply be that the backtest improves by implementing a profit target. Thus, you use a profit target in your live trading as well.
Is using profit target smart and rational?
We like to quantify, and in general terms, over the thousands of ideas we have tested over the last two decades, we have yet to see a consistent improvement in our trading strategies by using a profit target.
It’s more often the opposite: a profit target reduces overall profitability.
Why does the profit target reduce the profitability?
Because you cut the winners short, which should be a big no-no in trading.
Let’s illustrate profit target with practical examples:
Examples of how to test and use a profit target:
Below we test profit targets on the S&P 500 and Nasdaq by using the ETFs with the ticker code SPY and QQQ:
Let’s test profit targets on the S&P 500 and SPY:
Below is the equity curve of a trading edge that we later might publish as a monthly trading edge:
The backtest started with 100 000 in equity and ended with 336 715, which is 4.4% compounded. The strategy only gave 192 buy signals over the period, and this equals an average gain per trade of 0.65%.
Let’s throw in a profit target of 1% and see what happens:
(The exit price is exactly 1% or exits at the open if the open is higher than 1%.)
The overall equity goes down drastically: to only 210 840.
Let’s optimize and test how a different profit target changes the result:
Column 2 shows how the different profit targets change the overall result. The bigger the profit target, the better the result. In practice, this means that the profit target serves little purpose. When the profit target is higher than three percent, very few trades hit the target. As you can see, the strategy performs best without a profit target at all.
Let’s test profit targets on Nasdaq and QQQ:
Without any profit targets the equity curve looks like this from QQQ’s inception:
What happens if we put a profit target of 1%, just like we did with the S&P 500 above? The equity curve improves a lot:
What is not to like? About 66% of the trades exit at the profit target. QQQ is much more volatile than SPY and thus you are more likely to hit the profit target.
If we do the same optimization as we did with the S&P 500 we get this table:
While the S&P 500 worked best with a high or no profit target at all, Nasdaq works best with a low profit target. However, we fail to see a pattern except that a profit target seems to increase the profit factor on most target levels.
Should you use a profit target for Nasdaq in this strategy? That would be up to you. However, we most likely won’ because profit targets increase the risk of curve fitting:
Profit targets increase the risk of curve-fitting
We’re not saying the QQQ result above is curve fitted. However, the risk is there. The more parameters you put into your trading strategy, the more you risk fitting the past data and thus make it unlikely to work on future and unknown data.
Why is that?
First, most trading strategies are good because of a few large winners. A profit target cuts the winners short.
Second, just a few trades can alter the trading result hugely if you throw in a profit target. In reality, this is curve-fitting.
Conclusion: profit targets serves mainly to ease a trader’s mind
The two examples we provided in the S&P 500 and Nasdaq produced different results. That is normal as different assets behave differently.
Despite this, we don’t use profit targets in our own trading except for a few strategies. The reason being that profit targets rarely improve the results and if it does, we face the risk of curve-fitting the backtest.
We believe that the profit target is most useful to ease the mind of the trader. Why? It feels great to realize profits, and it feels terrible to see a profit turn into a lower gain, and not to mention into a loss.
That’s how we are as human beings. If you make 100 000 every year like clockwork for ten years, you have ten great years. If you make 1 000 000 in year one and nothing in the next nine years, you have one fantastic year and 9 miserable years of banging your head against the wall. Hardly anyone wants the latter version.
It’s understandable we choose what makes us feel great. The great majority of the adult population is overweight, even though we know it’s bad.
The same goes for profit targets.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.