What is a take profit order?
What is profit-taking?
A take-profit order (T/P) is a type of limit order that specifies the exact price at which to close out an open position for a profit. This allows a trader to apply risk management in an automated and consistent way based on any trading strategy.
Most traders use take-profit orders in conjunction with stop-loss orders (S/L) to manage their open positions. If a trade approaches the take-profit point, the T/P order is executed and the position is closed, securing any profits. If the security falls to the stop-loss point, the S/L order is executed and the position is closed for a loss.
Take-profit orders are best used by short-term traders interested in managing their risk. This is because they can get out of a trade as soon as their planned profit target is reached and not risk a possible future downturn in the market. Traders with a long-term strategy do not favor such orders because it limits their potential profits.
The benefit of using a take-profit order is that the trader doesn’t have to worry about manually closing a trade or second-guessing themselves. This lowers the possibility of human error and emotions such as greed getting the better of you, such as leaving a winning trade that has already reached your target open just to try to make more money.
Take-profit orders are often placed at levels that are defined by other forms of technical analysis, including chart pattern analysis and support and resistance levels.
How to use a take-profit like a professional trader
A take profit order is often used simultaneously with a stop-loss, which helps define your risk to reward ratio. Risk to reward and appropriate trade sizes are essential in determining how successful you are in the markets. Therefore, a take profit order allows you to limit your risk or exposure to the market by exiting your trade as soon as the an opportunity presents itself and not staying in any longer than anticipated.
Should you use a take profit order?
Whilst every trader is different in terms of trading strategy, risk profile and the time they stay in a trade. There are a few key questions you can ask to determine whether or not you should use a take profit order.
First, if you are a long-term/ swing trader, you are likely looking to take advantage of longer-term trends. Swing-traders who use take profit targets are often frustrated when they’ve recognized a good trend and get out very early and miss out on missed potential profits.
While the market is ranging, take profit orders are often preferred. It is because resistance levels often hold back price advances and support levels often hold up price drops. Therefore, if you are buying low in price moves up to resistance in a range-bound market, a take profit order at an elevated price is desirable before the market retraces closer to or below your entry point.
Pros and cons of take-profits
There are several benefits to trading with a profit target, some of which were briefly addressed above. However, there are also some drawbacks to using them.
The positive aspects of using take-profit include:
- By placing a stop-loss and a take-profit, the risk/reward of the trade is known before the trade is even placed. You will the best and worse can scenario, and based on that information you can decide if you want to take the trade.
- Profit targets, if based on rational and unbiased analysis, can help eliminate some of the emotion in trading since the trader knows that their profit target is set and in a good place based on the chart they are analyzing.
- If the profit target is reached, the trader capitalized on the move they forecasted and will have a reasonable profit on the trade. Assuming the trader was happy with the risk/reward of the trade prior to taking it, they should be happy with the result regardless of whether they win or lose. In either case, they took the trade because there was more upside potential than downside risk.
There are some potentially negative aspects of using take-profit as well:
- Placing profit targets requires skill; they should not be randomly placed based on hope or fear. Remember the importance of not trading with emotions.
- Take-profit targets may not be reached. The price may move toward the profit target but then reverse course, hitting the stop-loss instead. It can even reach 1 pip away before reversing. As mentioned, placing profit targets requires skill. If profit targets are routinely placed too far away, then you likely won’t win many trades. If they are placed too close, you won’t be well compensated for the risk you are taking.
- Take-profit targets may be greatly exceeded. When a profit target is placed, further profit (beyond the profit target price) is forfeited. If you place a trade at $7.50 and place a take-profit order $7.75, you give up any profits above $7.75. Remember though, you can always get back in and take another trade if the price continues to move in the direction you expect.
Day traders should always know why and how and they will get out of a trade before they enter. Whether a trader uses a take-profit to do this is a personal choice.
There are multiple ways a trader can exit a trade with a profit. Using a take-profit is the most consistent way to do this automatically, removing any human error or emotional attachment to a. trade. When you use a take-profit you are estimating how far the price will move and assuring that you will close realise your profits when that trade reaches your limits, instead of gambling on additional profits.
When you calculate your take-profits and stop-loss to ensure that the rewards outway your risk before you place the trade, you will know your best and your worst-case scenario. Which will close automatically with either a profit or a loss.