What Is A Take Profit And How To Use It In Forex Trading?
A take profit (TP) is an order placed by a trader to close a position at an exact price, for a profit. Take profits reduce the chance of adverse moves against a winning position, by automatically closing the position for a gain.
Make sure you catch the difference between the take profit and its cousin, the stop loss (SL). A TP secures a profit, while a SL limits losses.
The topics that will be discussed
- How to set take profit orders.
- Chart examples.
- Advantages and disadvantages of take profits.
How to set take profit orders?
Take profits are usually set by traders when a position is opened. Technical analysis is used to determine the price at which the market may stall or reverse against the winning trade, the take profit order is then placed at that level to automatically exit the position when the price is hit.
By doing this the trader locks in potential gains before the market is likely to reverse and eat away at their profits, nobody likes their food stolen! Tools such as horizontal support/ resistance, trendlines and measured moves out of patterns can be used to determine the placement of the TP.
In a buy position, the take profit is set above the market entry price, in a sell position the take profit is set below the entry price. The following are examples showing take profits in action.
On EURGBP we see how a take profit could be set in a range trade. When the market is ranging it is likely that the market will turn at the support and resistance levels. After buying on the bullish candle at support, the TP can be set at the resistance level since it is difficult for the market to breakthrough and price will likely reverse. Thus, it is probably best to take profits.
Here is an example of using a measured move to set a TP. A measured move refers to the expectancy that the market will move a similar amount as the previous pattern that it breaks out of.
NZDJPY had a range of 130 pips in the flag pattern, therefore the TP can be set 130 pips below the support level that was broken. The reason being that technical traders believe that their side (bulls or bears) might lose strength after extending a similar amount, and a reversal could occur.
Advantages of take profits
Firstly, take profits are a great way to lock in gains and prevent the market from completely reversing against a winning position. If a trader can accurately use other technical analysis tools to determine where the market may shift against them, then the take profit is the best option to maximize earnings.
Secondly, by using the SL and TP levels a trader can determine the risk to reward potential, and by extension determine if probabilities favor placing a trade or not (link to probabilities). Since traders always want probabilities to be on their side, this is a massive advantage.
Lastly, take profits decrease the effect of emotions on the management of a trade. The objective price to close the order helps to prevent greed clouding the decision making process.
Disadvantages of take profits
Although TP’s can secure profits, this management tool is a double-edged sword in the sense that it can also limit profit potential. You may be asking how? This seems against everything that we have discussed. The reason that this can occur is when momentum in a certain direction is strong, the market can easily break through levels and continue trending. Illustrating this is the NZDJPY example from earlier.
Check out How To Let Your Winning Trades Run for more on this.
It is clear to see that where we got out is nowhere near the overall move that the market made, in fact, the market fell another 700 pips after the TP exit (that is true heartbreak).
So how do you know when its best to use a TP in your trading or not? Shorter-term traders will probably be best getting out as soon as possible, so TP’s are likely the best option. While swing traders are best off trying to ride the trend as long as possible, so no TP and a trailing stop instead would probably be best.
But the only way to be sure, is to analyze your trades and determine what works best for your strategy.
Does your broker offer a variety of order types that allow you to manage your trades effectively? If not, consider switching to Plus500.
Now the ball is in your court, analyze your trading and determine if using TP’s is best for your wallet.
Happy searching, until next time.