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Two Ways to Establish Profit Targets on a Trade


A profit target is a common tool used by traders for exiting a profitable trade once a certain price or profit objective is reached. Once the order is set it stays pending (if a Good Till Canceled (GTC) order), exiting the trade for you  at the profit objective. Profit targets are typically used in conjunction with stop loss orders, which limit risk. By using a stop loss and a profit target, the price will eventually reach either the stop loss or the profit target, allowing for a more hands-off approach to trading.

There are numerous ways profit targets are established. Here are two of the main ways, which can be used in conjunction with one another.

Reward/Risk
Using both a stop loss and a profit target provides a reward/risk ratio. If you buy an S&P E-mini contract (ES) at 2000 and a place a stop loss at 1998, the risk is 2 points. Knowing the risk, a target is set based on the desired reward/risk ratio. For example, if a trader desires to make three times what they risk if the trade is profitable, a target is placed at 2006. This provides 6 points on the winner but if the trade is a loser it only costs 2 points.

Traders use various reward/risk ratios, and often try to establish if the profit target is likely to be reached using the 'measured move' method as well.

Measured Move
Based on recent chart patterns or price movements a profit target is placed . For example, if a triangle pattern is 30 points in height, a profit target is placed 30 points from the breakout of the triangle. Prior price action is used as a way to estimate what future price action will produce. If the price is moving in a trend channel, a profit target could be place near the top of the channel for long positions or near the bottom of the channel for short trades. Measured moves are covered in depth in the 5 Chart Patterns You Need to Know eBook.

Using Profit Targets in the Real World
Setting targets based on a reward/risk ratio is a good start, but should ideally be combined with measured moves. For example, placing a trade with a 10:1 reward:risk may sound great in theory, but if the target is way outside of how the market typically moves there is almost zero chance the target will be reached before the stop loss is hit. In this case, the reward/risk is favorable but the trade has a low probability of success. Traders instead look for trades which provide good reward/risk ratios (typically 1.5:1 or higher), but where the profit target still has a reasonable chance of being reached. Looking at measured moves aids in this regard. If conditions aren't favorable, the trade is left alone.

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