This week’s question comes from Mthandazo, who asks:
How long should one hold a profitable position?
There is a misconception that to become successful as a trader, you need a strike rate above fifty percent. In other words, you need more winning trades than losing ones.
In fact, nothing could be further from the truth.
What makes someone profitable in this business is their ability to make more money than they lose. That’s it!
It’s not whether you’re right or wrong that’s important, it’s how much money you make when you’re right and how much you lose when you’re wrong.
Mr. Soros hit the nail on the head when he said that.
Once you understand this, you can see how deciding when to take profit becomes paramount to your success. As I and others have said before, your winners have to pay for your losers.
It’s not enough to simply take profit as soon as you have some. In fact, traders who do so are at a much greater risk of blowing their account. These traders are cutting their winners short and letting their losers run.
The good news is that the concepts behind when and how to take profit are simple. When you think about it, you have just three options, each of which we’ll discuss in this post. I’ll also share my preferred method of taking profit, which simultaneously reduces risk.
Determine Your Profit Target in Advance
There are many aspects to the world of trading that rely on personal preference. These include the strategies you employ and the patterns you use.
However, determining your profit target in advance of opening a position is not up for debate.
It doesn’t matter if you trade pin bars or head and shoulders, or even combine fundamentals with your technical analysis. Regardless, determining a target in advance is always a wise decision.
Think about it this way –
A profit target is a goal, in the same way running a marathon may be a runner’s goal. And anyone who has set (and met) goals in life knows that the odds of reaching a goal increase exponentially when a commitment is made ahead of time.
It’s all about having a purpose. Just as the runner’s purpose is to run a marathon someday, every trade you take needs to have a purpose of potentially hitting a target.
Otherwise, you’re just risking money for the sake of having something to do. As Jack Schwager once said, the market is an expensive place to look for excitement.
Having a predetermined profit target also reduces the chance of making an emotional decision. The only time you have a truly neutral bias is in between trades, so it makes sense to use this time to define a realistic target.
Once you have money at risk, that neutral bias goes out the window. All of a sudden you have something to lose, which can adversely affect where you place your orders.
So always define your target in advance. This rule applies regardless of how you trade the Forex market because the goal is always the same – to limit losses and maximize profits. One of the best ways to do that is to eliminate emotional decisions.
Three Options for Taking Profit
Sometimes the best way to address any situation is to outline your various options. This helps to avoid emotional decision-making and often leads to more favorable outcomes.
When trying to decide when to take profit, you have just three options.
Close the position manually
The first and most obvious of the three is to close the position manually at an arbitrary price.
Perhaps you doubled your money, or maybe you just feel like it’s a good time to take profit. It’s your call but just remember that it’s a good idea to have a plan in place to avoid making an emotional decision.
The only time you may want to close a position prematurely is just before a major news event. If you think the market is about to become volatile, it may be a good idea to close your position and book those unrealized gains.
Outside of that, it’s generally best not to interfere. Devise a plan before you put on the position and then just let the market do the heavy lifting; that’s usually the best approach.
Wait for the market to hit your take profit order
In my opinion, this is by far the best way to close out a profitable position. It’s also the simplest way, so it fits my plan of keeping everything as straightforward as possible.
Now, what trips up most traders is figuring out where to place the profit target.
Should it be a set distance? What about those key levels?
To the first question, the answer is always no, at least for the way I trade. I would never just place my target 50, 100 or 200 pips away from my entry. If you do that, you’re ignoring the key levels that help direct the ebb and flow of the market.
Which brings me to the second question – what about those key levels?
That’s what you should ask yourself every time you define a target. It doesn’t matter what strategy or technical pattern I’m trading, I always use the key levels to figure out where my order should go.
In other words, it’s going to vary for each setup. This is why it’s vital that you learn how to draw support and resistance so that you can use these levels to strategically place your orders.
Last but not least, the target for a trade should never be based solely on the amount of pips between your entry and stop loss.
For instance, I often hear traders saying that their risk for a trade is 50 pips, so in order to achieve a 2:1 reward-to-risk ratio, they placed their target 100 pips from their entry.
The issue here is that they have no idea whether the price that’s 100 pips away is significant. Their only reason for placing it there was to achieve a favorable risk-to-reward ratio.
Don’t make that mistake.
When trading with price action, profit targets should always be placed at or around key support and resistance levels. Anything less is arbitrary and therefore means nothing to other market participants.
Trail your stop loss order in lieu of a profit target
A third way to take profit involves trailing your stop loss. When you choose this method, you’re simply trailing the order as the market moves in your favor.
Some traders will use the stop loss order in place of a profit target. For instance, if the EURUSD were in a steep downtrend, you may want to avoid setting a hard target and instead trail your stop loss to lock in as much profit as possible.
While this works great in a trending market, trailing a stop loss in place of a hard target in a range-bound market isn’t quite so advantageous.
Notice how you would have given up quite a bit of profit had you solely used your stop loss in the ranging market above.
So just remember, this option is best employed during strong trends. It allows you to lock in profit as the market moves in your favor and doesn’t limit you to a single hard target.
If you do choose this method, I would advise you to determine a soft target so you can still calculate the risk-to-reward ratio. In other words, pick a level you believe is likely to be hit if your analysis is correct. You don’t have to take profit here, you’re just using it to calculate the profit-to-loss ratio.
Of course, you can use option two and three together and get the best of both worlds.
My Preferred Method
I like to keep things simple. This goes for the trading strategies I employ, as well as the methods I use to limit losses and maximize profits.
When it comes to booking profits, I like to use a one-two punch.
Since I always use a stop loss order, it’s easy enough to trail it as the market moves in my favor. This reduces and eventually eliminates the risk while locking in profit along the way.
I also always define a realistic profit target before committing to any position. By deciding beforehand, I eliminate some of the emotions I might otherwise experience.
Also, as mentioned above, defining a target up front allows me to determine whether the setup meets my criteria of a 3:1 reward-to-risk ratio.
After more than a decade of experience and hundreds if not thousands of trades, I’ve found this to be a winning combination.
But while this works for me, it doesn’t mean it will work for you. For this reason, it’s important that you test various methods to see what fits your personality and style of trading.
Regardless of how you decide you take profit on your open positions, determining your target in advance is always a smart decision. It eliminates the risk of making an emotional decision and ensures you’re only taking setups with favorable risk-to-reward ratios.
At the end of the day, there are really only three options for booking profit. You can either close the position manually, let the market hit your take profit order or trail your stop loss.
My preferred method for booking profits is to use key levels to determine an exit price. In addition, I always trail my stop loss to some degree, in order to take some risk off the table and eventually begin locking in profit as the trade moves in my favor.
Your Turn: Ask Justin Anything
I’d love for this new weekly Q&A to be successful and provide an invaluable repository of answers to common Forex questions.
To do that, I need your help.
Here’s what you can do to get involved and have your question answered in next week’s post:
- Ask questions. Post them in the comments below or Tweet them to me @JustinBennettFX
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