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One of the most challenging aspects of trading is setting a realistic and probable profit target. In fact, most traders that I’ve talked to over the years would put taking profits above entry strategies in terms of where they struggle the most.
It is true that knowing where to take profits can be harder than finding favorable entries, but it doesn’t have to be. By using something called a measured objective, we can determine a realistic profit target for a myriad of price action patterns.
In this lesson, we’re going to take a look at how to use measured objectives to find profit targets that are both realistic and probable.
More specifically, we will discuss how to calculate the measured objective for four common price action patterns. Those patterns include the double top, head and shoulders, equidistant channel and wedge pattern.
Let’s start by defining what a measured objective is and what it can tell us about future price action.
Every price action pattern has a role to play. Whether it’s a topping pattern, bottoming pattern or continuation pattern, each one represents a critical piece of the puzzle when evaluating a market’s behavior.
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These patterns not only give us insight into a possible trend change or continuation, they also allow us to gain an edge when assessing the extent to which a market is likely to move as a result of such patterns. These moves are referred to as “measured moves”, which is the distance measured from the break of the pattern to the measured objective.
The image below illustrates the difference between the measured move and measured objective.
Notice in the illustration above, the measured move is the same distance as the move leading into the channel. Therefore the measured objective becomes our profit target once price breaks channel support.
Now that we’ve defined the difference between a measured objective and a measured move, let’s take a look at how to calculate profit targets for four common price action patterns.
The double top pattern is a topping pattern which typically forms after an extended move up. As the name implies, it forms after the market fails on a second attempt to make a higher high.
To find the measured objective, we simply need to measure the distance in pips from the high of the pattern to the neckline and then extend that same distance from the neckline to a lower level in the market.
The illustration below shows how to calculate the measured objective for a double top pattern.
In the event one of the highs that formed the double top is higher than the other, you should use the distance from the lower high. This will keep your measurement conservative, which helps to avoid setting a profit target that may be too ambitious.
The next pattern on our list, which is also a reversal pattern, is the head and shoulders. Like the double top, this pattern occurs after an extended move up and signals a possible reversal in the market.
To find the measured objective for a head and shoulders pattern, we need to measure the distance in pips from the head to the neckline and then extend that same distance from the neckline to a lower level in the market.
This pattern is a bit different from the double top in that the neckline isn’t always a horizontal level. In fact, the neckline is most often represented by a diagonal level, such as the one in the illustration below. This means that we have to take into account the level at which price breaks down from the pattern when calculating the measured objective.
The image below illustrates how to calculate the measured objective for a head and shoulders pattern.
Take note that the measurement from the head to the neckline occurs at a different area than that of the measurement to find the objective. There is some overlap between the two as the neckline is not a horizontal level. This is important to keep in mind as it will affect the placement of your profit target.
Now we’re going to switch from reversal patterns to continuation patterns. Using a measured objective in combination with an equidistant channel break can be a powerful combination.
With the exception of the wedge pattern, which we will discuss next, the equidistant channel is my favorite pattern to trade. This is partly due to the fact that they occur quite often and partly because they come with a measured objective that is more accurate than not.
Here’s how to calculate the measured objective for an equidistant channel.
The key to calculating a measured objective for an equidistant channel is to use the entire move up or down as the measured move. Notice how the first and second move down in the image above are colored black. That black line represents 400 pips and overlaps part of the channel pattern.
So just remember to include the entire move into the channel as part of the measurement. The same goes for calculating the objective on the other side of the pattern.
Last but not least we have the wedge pattern. This is my favorite pattern to trade with the equidistant channel coming in at a close second. Wedge patterns are best traded on the four hour time frame and higher and actually occur quite often once you train your eyes what to look for.
Although most often seen as a continuation pattern, wedges can also trigger reversals. However, it doesn’t really matter whether a wedge is a continuation pattern or a reversal pattern as we don’t commit to a position until the market breaks support or resistance.
To find the measured objective for a wedge pattern, you simply take the height of the pattern in pips and project that same distance to a future point in the market.
The illustration above shows how to calculate the measured objective for a wedge pattern. The height of the pattern is measured from the first touch on either side of the wedge. Once you have that figure, in this case, 400 pips, you extend that same 400 pips to a future point in the market in either direction.
In order to get an accurate measurement, it’s important to wait for the market to break support or resistance. This is because the measured move begins as soon as the market breaks out from the wedge.
No measured objective is complete without combining it with a key level of support or resistance. In fact, I will often put a key level ahead of a measured objective when determining an area to take profits. This is because, depending on how significant the level is, it will often “outweigh” a measured objective in terms of where the market is likely to reverse.
So if the measured objective for a pattern is 400 pips away, yet a key price action level is just 350 pips away, always aim for the key level first. It’s better to be conservative and book 350 pips of profit than to try and squeeze an extra 50 pips out of a trade and run the risk of making nothing.
Like everything when it comes to trading, there are no guarantees and no strategy or technique is without flaw. Using measured objectives to identify profit targets is no exception.
Although measured objectives are typically quite accurate, there will be times where the numbers don’t match up. For this reason, you should think of a measured objective as a gauge of how far a market could move rather than a determination of how far a market will move.
Do you currently use measured objectives as part of your trading plan? If not, do you think you will start using them having read this lesson?
Leave your comment or question below. I look forward to hearing from you.
Justin Bennett is an internationally recognized Forex trader with 10+ years of experience. He's been interviewed by Stocks & Commodities Magazine as a featured trader for the month and is mentioned weekly by Forex Factory next to publications from CNN and Bloomberg. Justin created Daily Price Action in 2014 and has since grown the monthly readership to over 100,000 Forex traders and has personally mentored more than 3,000 students.Read more...
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