When to Take Profits

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Reference ID: #3d6a5a40-775f-11ea-b196-21d83afe546b

Take-Profit Order – T/P

What is a Take-Profit Order – T/P

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.

Basics of a Take-Profit Order – T/P

Most traders use take-profit orders in conjunction with stop-loss orders (S/L) to manage their open positions. If the security rises to the take-profit point, the T/P order is executed and the position is closed for a gain. If the security falls to the stop-loss point, the S/L order is executed and the position is closed for a loss. The difference between the market price and these two points helps define the trade’s risk-to-reward ratio.

The benefit of using a take-profit order is that the trader doesn’t have to worry about manually executing a trade or second-guessing themselves. On the other hand, take-profit orders are executed at the best possible price regardless of the underlying security’s behavior. The stock could start to breakout higher, but the T/P order might execute at the very beginning of the breakout, resulting in high opportunity costs.

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 cuts into their profits.

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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, or using money management techniques, such as the Kelly Criterion. Many trading system developers also use take-profit orders when placing automated trades since they can be well-defined and serve as a great risk management technique.

Key Takeaways

  • Take-profit orders are limit orders that are closed when a specified profit level is reached.
  • Take-profit orders are placed using technical analysis.
  • Take-profit orders are beneficial for short-term traders interested in profiting from a quick bump in the security costs.

Take-Profit Order Example

Suppose that a trader spots an ascending triangle chart pattern and opens a new long position. If the stock has a breakout, the trader expects that it will rise to 15 percent from its current levels. If the stock doesn’t breakout, the trader wants to quickly exit the position and move on to the next opportunity. The trader might create a take-profit order that is 15 percent higher than the market price in order to automatically sell when the stock reaches that level. At the same time, they may place a stop-loss order that’s five percent below the current market price.

The combination of the take-profit and stop-loss order creates a 5:15 risk-to-reward ratio, which is favorable assuming that the odds of reaching each outcome are equal, or if the odds are skewed toward the breakout scenario.

By placing the take-profit order, the trader doesn’t have to worry about diligently tracking the stock throughout the day or second-guessing themselves with regards to how high the stock may go after the breakout. There is a well-defined risk-to-reward ratio and the trader knows what to expect before the trade even occurs.

Profit-Taking

What Is Profit-Taking?

Profit-taking is the act of selling a security in order to lock in gains after it has risen appreciably. While the process benefits the investor taking the profits, it can hurt other investors by sending shares of their investment lower, without notice.

Profit-taking can affect an individual stock, a specific sector, or the broad financial market. If there is an unexpected decline in a stock or equity index that has been rising, with no news or external events to support a selloff, it may be attributed to many investors taking profits.

Key Takeaways

  • With profit-taking, an investor cashes out some gains in a security that has rallied since the time of purchase.
  • Profit-taking benefits the investor taking the profits but can hurt an investor who doesn’t sell, as it pushes the price of the stock lower, at least in the short-term.
  • Profit-taking can be triggered by a stock-specific catalyst, such as a better-than-expected quarterly report or an analyst upgrade.
  • Profit-taking can also hit a broad sector or the overall market; in this case, it might be triggered by a bigger event, like a positive economic report or a change in Federal Reserve monetary policy.

Understanding Profit Taking

While profit-taking can affect any security that has advanced (e.g., stocks, bonds, mutual funds, and/or exchange-traded funds), people use the term most commonly in relation to stocks and equity indices.

A specific catalyst often triggers profit-taking, such as a stock moving above a specific price target; however, profit-taking may also occur simply because the price of a security has risen sharply in a short period of time. A catalyst that frequently triggers profit-taking in a stock is the quarterly or annual earnings report (SEC Forms 10-Q or 10-K, respectively). This is one reason why a stock may be more volatile in the weeks surrounding the period when it reports results.

If a stock has gained significantly, traders and investors may take profits even before the company reports earnings in order to lock in gains rather than risk profits dissipating if the earnings report disappoints. Investors may also take profits after earnings are reported to prevent further declines (e.g., if the company has missed expectations on earnings per share, revenue growth, margins, or guidance).

Taking Profits in a Specific Sector

Profit-taking in a specific sector—even against the backdrop of a strong bull market—could be triggered by an event specific to that sector. For example, a bellwether stock could report unexpectedly weak earnings in an otherwise hot sector, which could subsequently trigger profit-taking across the entire sector, due to fear. If a promising tech company had a poor initial public offering (IPO), investors might be keen to exit the sector overall.

If the profit taking is one-time event-driven—such as in response to a profit report—the overall direction of the stock is unlikely to change long-term, but if the profit-taking is in response to a bigger issue (such as worries about economic policy or other macro issues) longer-term stock weakness could be a risk.

Broad Market Profit-Taking

Profit-taking in the broad market is usually a result of economic data, such as a weak U.S. payrolls number or a macroeconomic concern (such as concerns over high levels of debt or currency turmoil). In addition, systematic profit-taking could occur due to geopolitical reasons, such as war or acts of terrorism.

It is important to note that profit-taking is typically a short-term phenomenon. The stock or equity index may resume its advance once profit-taking has run its course. Yet a concerted bout of profit-taking that knocks a stock or index down by several percentage points could signal a fundamental change in investor sentiment and portend additional declines to come.

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