Knowing when to accept your profits is key to successful day trading. However, many people often think that you can earn more by letting your profits run. This strategy almost always fails, and it is why I find that setting profit targets is one of the few ways to guarantee that you turn a market gain into a monetary gain.
The main principle behind using profit targets is that it helps you to control your emotions. When people exit a trade, they are usually too early or too late. Most people cannot pick tops and bottoms, or at least not consistently. What often happens, then, is that people get out too early, see the market continue to move in their direction, and feel tempted to re-enter. They often grow angry at themselves for leaving too early and want revenge. So they enter again. But now, of course, it is too late, and the trend is already exhausted. As soon as they enter, prices move against them, and they realize a loss.
In this situation, regret, revenge, and greed take over and end up costing someone money. But the same thing can happen when people get out too late. Let’s assume a trader was right about the direction of the market and saw $500 in profits. He haven’t taken any, since he wants to let his profits run. But now the market retraces, and his unrealized profits decrease to $400. He now thinks to himself, “This is a normal retracement, and I’m sure the market will continue in my direction very soon.”
But it doesn’t. His unrealized profits shrink to $300, and now he comes up with a plan: “As soon as the market recovers and I see $500 in profits again, I exit”. And it really happens. The market bounces back and he sees $400 in unrealized profits. But then the market retraces again, and his profits shrink to $200. He wonders if this is a “normal” retracement or if the trend is exhausted. At this point he is uncertain when to exit, and this indecision paralyses him. He sits and waits, hoping that the market moves again in his direction.
But, still, it never happens. Prices are now hovering around his entry price, but since he has already seen $500 in (unrealized) profits, he doesn’t want to exit at break-even. He thinks, “The market will come back, the trend looks still strong”, and starts justifying his position. He is desperately looking for clues that the market will continue to move in the right direction, and he might plot more indicators on the chart or even change to a different time frame.
With all this additional information, he now feels more confident that this is only a retracement, and that the market will bounce back shortly. But doubt remains, and he decides to take profits as soon as he sees $250 in unrealized profits. He is so focused on “being right” that he doesn’t realize how he is fooling and defeating himself. The market continues to go against him, and, instead of getting out of the trade, he looks at more indicators, more timeframes, more information. But all he has really done is to let a winning trade turn into a losing trade.
Profit targets can eliminate this kind of problem. Use a profit target and a stop loss, and put the trade on autopilot. Then, if the market moves beyond your profit target, leave it alone. Be happy and contend with your profits. After all, you realized profits. The key to trading success is to be right about the direction of the market, and then to realize the profits. Paper-profits are not worth anything. Take your money off the table as long as it is there!