In this article, you’ll learn what a profit target is by definition, how to understand it in the context of proprietary trading, and how to apply the right profit target type when trading.
Profit Target Types
The term profit target has a special meaning in the context of prop trading. The profit target in prop trading firms defines the overall target of how much a trading account has to grow in order to get funded by the prop firm.
The profit target is the overall amount of profit that has to be reached. Let’s say you have a $25K challenge where you see a profit target with a $2,000 value. That means that you have to make a profit of $2,000 (in total) in order to get funded.
In addition, profit targets are also a regular term among traders and investors. Here are the three main types:
Profit Targets With Static Risk Reward Ratios
Using a static risk reward ratio is a common approach to setting profit targets. This involves setting a target that is a multiple of the amount risked on the trade, such as 1:2 or 1:3.
Example: If a trader risks $100 on a trade, they would aim for a profit of $200 or $300, respectively. This method makes it possible, that winning trades are larger than losing ones, which is necessary for overall profitability.
The exact ratio used depends on the win rate and strategy. Higher win rates can use lower ratios, while strategies with lower win rates need a higher risk-reward ratio to compensate.
Profit Targets With Technical Analysis
Another method for setting profit targets is using technical analysis to identify key support and resistance levels on the price chart.
Example: Open your E-Mini S&P 500 futures chart and highlight the support and resistance zones. Now, you can determine reasonable profit targets that stay in good ratio to the stop loss levels.
Resistance levels are where the price may struggle to break above, while support levels are where the price could bounce higher.
By projecting profit targets based on these levels, traders can set exit points where the price is likely to stall or reverse. For example, if a stock breaks above resistance, that level could become support and a reasonable area to take profits before the price potentially drops back down to test that level again.
ATR Profit Target Method
The average true range (ATR) is a measure of volatility that can also be used to set profit targets. The ATR represents the average price range over a certain number of bars. Traders can set profit targets that are a multiple of the ATR, such as 2x or 3x the ATR value.
These factors affect the stock’s recent volatility and profit target. More volatile stocks will have higher ATR values and, thus, higher profit targets, while less volatile stocks will have lower targets. This approach adapts the target to the particular stock and recent market conditions. The ATR method is, to some extent, similar to the static profit target method.
Wrap Up
Profit targets should be set at the beginning of the trade, not while the trade is already in progress. This helps remove emotion and bias from the decision-making process.
If a profit target is not set in advance, a trader may be tempted to prematurely exit a winning trade out of fear of giving back profits, or they may let a losing trade run too long, hoping it will turn around.
By setting profit targets before entering a trade, the trader knows exactly when to exit ahead of time and can do so objectively. This also makes it easier to measure the strategy’s performance over time.
It’s important to remember that profit targets don’t have to be hit exactly to the penny. Depending on the strategy, it may make sense to scale out of a position as the price approaches the target.
Example: A trader could close half the position at the initial profit target and then aim for a further target with the remaining half to let the winning trade run. Alternatively, they could set multiple profit targets at different levels and scale out gradually. This approach balances locking in some gains while giving the remaining position room for the trend to continue. The best tactic depends on the specific setup and market conditions.
