Profit Target vs Trailing Stops
Whether to use a Profit Target (Tgt) or a Trailing Stop (TSL), or a combination of both? This is one of the most fundamental questions in position sizing of trades. Let us first go through the benefits of each.
Benefits of using a Profit Target
1. Improves the percentage of winners
2. Reduces the average period of drawdown
3. Easy to set, because the Profit Target can be determined using backtested risk/reward ratio
4. Easy to set using chart levels- the trader feels comfortable with a clear expectation of trend
5. The trader will miss the profits from a big move
6. Suitable for short-term or arbitrage related strategies
Benefits of using a Trailing Stop Loss
1. Allows participation in big moves
2. Stops out more often in trades resulting in lesser % of winners
3. Suitable for trend following strategies
We now see that each method has distinctive advantage, and in general, it always easier to book profit than waiting for the TSL to hit.
However, the returns from market do not follow a normal distribution. The markets- and consequently the returns of a strategy- show skewness, and we are back whether to favor positive skewness (by placing Tgt) or positive skewness (by placing TSL). The amateurs tend to go for a large % of wins which are negatively skewed. The professionals understand that it is the big move which makes big money. In almost most strategies pursued by a retail, it is advisable to go for TSL rather than setting Tgt.
Using a combination of Tgt and TSL
Sounds like eating your cake and having it too. When both are combined, you will still continue to miss big moves because of Tgt, and at the same time get stopped out more often by TSL. So when both are combined, the strategy suffers from the weaknesses of both methods rather than benefiting from the strengths.
Is there any way to Increase the Expectancy of Trades further
Yes there is. Simply divide your trade size in two halves for scaling-in to the trade. Let’s us move further with a practical example.
Case A: Buy 100 shares @8020 with TSL of 15 points. Assume TSL gives exit of 100 shares @8050
The profit to loss ratio will be 30/15= 2.00
Case B: Buy 100 shares @8020 with TSL of 15 points. Exit 50 shares for profit target @(8020+15) and 50 shares at 8050.
The profit to loss ratio will be 22.5/15= 1.50
Case C: Buy 50 shares @8020, 50 shares @(8020+15) and assume same TSL exit of 100 shares @8050
The average trade price will be 8027.5 and profit to loss ratio will be 22.5/7.5 = 3.00!!
Increasing the profit to loss by 50% is a huge jump! In practice, using such position sizing, traders can always increase their profit potential.