Using Take Profit Levels to Deal with Black Swan Events
A take profit level or order, often also referred to as a limit order, refers to a point where the trader is satisfied with the profit the trade has generated and wishes to exit that trade.
A take profit order is usually set up when the expected upside of the trade is limited and the trader wants to limit the risk of losing whatever profit he or she has realised on that trade. When used during a short trade it can allow the trader to cash in on so-called Black Swan events i.e. unexpected downward movements in price due to a catastrophic event affecting the marketplace.
Warning and Advice
There is an old saying in the world of trading that goes “Cut your losses and let your profits run”. This remains true when you trade with a take profit order. If you do not allow your trades to fully develop their profit potential and you allow losses to increase, you will make small profits and large losses – not a good trading strategy in any language.
More traders lose money by cashing in on profits too early than through probably any other trading mistake.
Setting up a Take Profit Point
When setting up your take profit point, you therefore have to set it up in such a way that it will lock in potential profits, not lock you out of any potential profit. When used correctly, a take profit level can actually prevent you from making this deadly trading mistake, because it will force you to ‘let your profits run’ until it becomes clear that the trade has turned around and is heading in the opposite direction.
As we have said before, a take profit level can be effectively used both in long and short trades. The aim remains the same: to allow the trade to fully develop yet to cash in before you lose a major part of the profits you could have made on that trade.
Figure 11.14(a) presents a simple example of the effective use of take profit levels. It is a chart of the gold price for the last four months. We use a combination of two technical indicators: a 30-day moving average (blue line) and a 14-day moving average (red line).
The system we will use is to enter into a long or short trade whenever the price crosses the 30-day moving average and to exit again when it crosses the 14-day moving average in the opposite direction. In this example, we would therefore have entered into a long trade at point A when the price broke through the blue 30-day moving average.
Setting up a mental take profit level at point B where the price crosses back through the 14-day moving average when you enter the trade and sticking to this no matter what would have ensured that you captured more than 80% of the upswing in the price of gold.
Entering a short trade at point C where the price crossed the 30-day moving average in a downward direction and exiting that trade again at point D when it crossed upwards through the 14-day average would once again have ensured a very nice profit from a largely unexpected downswing in the price of gold.
One can also use various other techniques, such as Fibonacci extension levels to achieve the same results.