Like stop losses, profit targets are one of the most common and yet one of the most misunderstood aspects of trading systems. As a general rule, retail traders love profit targets, especially small profit targets. Retail traders tend to favour small profit targets because they know that the smaller the profit target the greater the chance that this particular trade will be a winner; the smaller a trading system's profit target is, the more frequent the winning trades will be.
Almost all retail Forex traders accept that losses are part and parcel of trading and that provided there is more money being won than being lost the losses should just be considered as part of the 'cost of doing business', but usually this 'acceptance' is nothing more than a mental acceptance. While they accept that losses are part of the course mentally, they don't accept it emotionally. Their non-acceptance emotionally means that there is always a feeling that yes there will be losing trades sometimes, but this particular trade has to be one of the winners, so they are inclined to take a small profit when they have it rather than risk losing it. Small profit targets do this for them nicely.
Most good long-term trend following system don't have profit targets and simply aim to 'ride the trend until it ends' as the old saying goes, aiming to take much profit as the market will give them. I usually tend to favour these types of trading systems and believe that long-term trend following systems are generally the best types of Forex trading systems around, but I do realise that there is a place for profit targets in many good trading systems. Like stop-losses, what is and isn't a suitable value for a profit target depends on the system and the state of the market(s) the system is going to be used on at that time but I will nevertheless attempt to illustrate the folly of using very small profit targets by performing a series of simple tests on recent Forex data.
The Experiment,
To test the effect of using profit targets I'm going to use a simple system with two simple moving averages, a 10-day SMA and a 100-day SMA. The system's rules are as follows -
When the price crosses to close above the 10-day SMA and the 10-day SMA is greater than the 100-day SMA go long with a 3-day time-based exit.
When the price crosses to close below the 10-day SMA and the 10-day SMA is less than the 100-day SMA go short with a 3-day timed-based exit.
By "crosses to close above" is meant a day when the price closes above it's 10-day SMA when the day previous to that it didn't close above it's 10-day SMA. By a 3-day time-based exit I mean that orders will be set to close after 3 trading days or if the market price reaches it's profit target, whichever happens first.
This test will be performed on the four major currency pairs (EUR/USD, GBP/USD, USD/CHF and USD/JPY) from the beginning of 2006 to the end of 2010. The results are -
EUR/USD -
Profit Target
Number Of Wins
Number Of Losses
Winning Trades Percentage
Number Of Pips Won
Number Of Pips Lost
Pips Won To Lost Ratio
50
75
29
72.11%
3,533.70
4,108.30
0.86 to 1
100
68
36
65.38%
5,481.70
4,631.60
1.18 to 1
200
62
42
59.61%
6,296.30
5,228.90
1.20 to 1
300
61
43
58.65%
6,112.40
5,307.90
1.15 to 1
400
61
43
58.65%
6,215.50
5,307.90
1.17 to 1
N/A
61
43
58.65%
6,431.50
5,307.90
1.21 to 1
GBP/USD -
Profit Target
Number Of Wins
Number Of Losses
Winning Trades Percentage
Number Of Pips Won
Number Of Pips Lost
Pips Won To Lost Ratio
50
59
32
64.83%
2,950.00
5,600.10
0.53 to 1
100
53
38
58.24%
4,892.80
6,544.90
0.75 to 1
200
43
48
47.25%
5,930.90
7,739.00
0.77 to 1
300
40
51
43.96%
5,565.80
7,921.00
0.70 to 1
400
40
51
43.96%
5,618.30
7,921.00
0.71 to 1
N/A
40
51
43.96%
5,476.80
7,921.00
0.69 to 1
USD/CHF -
Profit Target
Number Of Wins
Number Of Losses
Winning Trades Percentage
Number Of Pips Won
Number Of Pips Lost
Pips Won To Lost Ratio
50
76
41
64.96%
3,722.60
4,621.30
0.80 to 1
100
61
56
52.14%
5,120.00
5,573.70
0.92 to 1
200
52
65
44.44%
4,696.60
5,965.40
0.79 to 1
300
51
66
43.59%
4,197.30
5,966.40
0.70 to 1
400
51
66
43.59%
4,197.30
5,966.40
0.70 to 1
N/A
51
66
43.59%
4,197.30
5,966.40
0.70 to 1
USD/JPY -
Profit Target
Number Of Wins
Number Of Losses
Winning Trades Percentage
Number Of Pips Won
Number Of Pips Lost
Pips Won To Lost Ratio
50
60
31
65.93%
2,892.10
4,209.50
0.69 to 1
100
44
47
48.35%
3,226.70
5,273.40
0.61 to 1
200
41
50
45.05%
3,758.20
5,400.50
0.70 to 1
300
41
50
45.05%
4,402.20
5,400.50
0.81 to 1
400
41
50
45.05%
4,404.50
5,400.50
0.82 to 1
N/A
41
50
45.05%
4,519.50
5,400.50
0.84 to 1
Profit Targets: My Conclusion,
As I wrote in my article on stop losses and profit targets what is, and isn't suitable as a stop loss, depends on the state of the market at the time. I'd urge the reader to read my article on stop loss and profit targets where I wrote about how what is a suitable stop loss and profit target depends on the state of the market if they are in any doubt about what I mean by this.
Between the beginning of 2006 and the end of 2010 the EUR/USD was largely in a state of trending, without to much volatility. Profit targets almost always degrade the performance of trend following systems during quiet but trending markets – the best approach to markets in this state is simply to 'ride the trend until it ends' and attempt to extract as much profit as the market will give you. Most of the best Forex trading systems that I have come across seek to do this.
More volatile markets like the GBP/USD and the USD/CHF performed better (or at least less badly, I would not recommend trading this particular system on any market) with a moderate profit target, while a tiny profit target of 50 pips over a 3-day period generally performed pretty poorly. What remained totally consistent on all markets however was, as I expected, the smaller the profit target the higher the percentage of winning trades but not necessarily the better the result. And this of course is the great danger; it's really tempting to use the profit target that will produce the highest percentage of winning trades, rather than the profit target that will produce the best results...
