As any risk disclosure will tell you, trading financial instruments puts the trader at risk of losing some or all of their allocated capital. Regardless if one is involved in cryptocurrency, shares, or forex trading, this is an indisputable fact. That's why astute traders implement strategies that include concrete risk management parameters.
A key aspect of managing risk is clearly defining when to exit an open position. In the live market, positions have two potential results: profit and loss. For those who meet their financial goals, risk and reward are aligned, ensuring that long-term gains outweigh losses. To accomplish this objective, various order types are used including the stop loss and take-profit.
Read on to learn more about the take-profit order and how it is used to optimise trading performance and efficiency.
What Is A Take-Profit Order?
A take-profit order, also known as a profit target or t/p order, is an order that defines the exit point of a positive open position. It is the market price at which a winning trade is closed and financial gain is realised.
Take-profits come in an array of types, each unique to the strategy being implemented. However, a trader may engage the market of a financial instrument in only two ways at any given time: the trader may buy (go long) or sell (go short).
Ultimately, the type of order being used as a take-profit is directly dependent on whether the open position is long or short.
A long position is opened when the trader buys a security. As the current market price rises from the entry point, unrealised gains grow making the position a success.
For instance, let's assume Trader A decides to buy 1 lot of the EUR/USD from 1.0700. If the market price rises above 1.0700, the position becomes financially positive; if price falls beneath 1.0700, it is negative.
To lock in a gain from a positive long EUR/USD position, Trader A would use a take-profit order to exit the market. In order to close out the long position, Trader A would need to sell 1 lot of EUR/USD. The sell may be executed in three ways:
- Limit Order: A sell limit order may be placed at a desired price level above the EUR/USD 1.0700 entry. This order rests at market as a set take-profit until price reaches the specified threshold.
- Market Order: Upon the EUR/USD long position going positive above 1.0700, a sell market order may be executed. When the sell market order is entered by Trader A, a sell is filled immediately at the best available market price.
- Trailing Stop Loss: A trailing stop loss order is a more sophisticated way of locking in profits on an open position. In the case of a long position, the trailing stop is a sell stop order located beneath price. As price moves up, the trailing stop does as well. If the EUR/USD moves above the 1.0700 entry by more than the stop loss margin, then a profit will be realised when price hits the sell stop order.
A short position is opened when a trader sells a security. Short positions become profitable when market price falls beneath entry; they go negative if price rises above entry.
To illustrate the shorting dynamic, let's say that Trader A decides to sell the EUR/USD from 1.0700 instead of buy. Given this scenario, Trader A will need to buy the EUR/USD to close out a positive short position under 1.0700 and realise a profit. Once again, this may be done in three ways:
- Limit Order: For an open short position, a buy limit order can be used to harvest profits. The buy limit is placed beneath market entry, where it waits until hit by price. Through using the buy limit order(s), Trader A may lock in gains at one or more preset take-profit levels.
- Market Order: Trader A may enter a buy market order and become a EUR/USD profit taker beneath 1.0700. Upon an acceptable price being reached, Trader A can execute a buy market order and immediately close out the short position at the best available price.
- Trailing Stop Loss: For the open short, Trader A may place a trailing buy stop loss order above entry. As the EUR/USD market price falls beneath 1.0700, the trailing buy stop order will move down as well. If the buy stop is hit beneath 1.0700, the short position will be closed in profit.
Pros & Cons Of Take-Profit Order Types
As in all facets of trading, the market order, trailing stop and take-profit limit order each have unique pros and cons. At the end of the day, it's up to each trader to decide which functionalities are best suited for their strategy.
Limit orders are the go-to take-profit mechanism for millions of active traders worldwide. Here are the key pros and cons of limit orders:
- Pros: Take-profit limit orders are ideal for strategies that require precision. Also, they rest at market until filled, so multiple take-profit levels may be defined on one trade.
- Cons: Limit orders may go unfilled and cause traders to miss out on realising gains. During periods of illiquidity or heavy volatility, limit orders have a greater chance of being left unfilled. Over time, this can severely undermine performance.
Many market participants prefer to lock in gains by using market orders. Here are the key benefits and drawbacks:
- Pros: Market orders are executed instantly, thus open positions are closed out fast. This functionality is beneficial to investment, swing trading and day trading strategies that do not require precision.
- Cons: With market orders, losses from order slippage can be significant. In thin or hyperactive markets, actual fill prices may vary wildly from order prices. This can negatively impact performance.
Trailing stop orders are used by breakout, trend and reversal traders interested in their dynamic functionality. Here are the pros and cons:
- Pros: Trailing stops provide the trader an opportunity to profit while limiting risk with respect to evolving price action. Amid a strong breakout or trend, realising extraordinary gains is possible.
- Cons: When hit, a trailing stop becomes a market order. Thus, fill slippage can negatively impact P&L.
Active trading may be a lucrative endeavour when conducted within the context of a viable trading plan. Also, a key part of any such plan is exiting the market efficiently at a gain or a loss. The take-profit order, stop loss order and risk vs reward ratio are key elements in establishing a consistent P&L.
For positive positions, the take-profit order furnishes the trader with a way of realising financial gains. This may be done by setting limit orders, executing market orders, or implementing trailing stops. Each of these order types is typically accessible via standard trading platform functionality.
The strategic importance of take-profit orders can't be understated. Traders are advised to quantify the type of take-profit, as well as the location, before opening a new long or short position in any market. Although past performance is not indicative of future results, regular application of take-profit orders can help establish longevity in the marketplace.
FXCM Research Team
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