"Cut your losses short and let your profits run."
When a Forex traders decides to open a position, usually he has some profit target in mind. Often such target is set as a take-profit order for the position. Sometimes, traders set multiple profit targets for one position and close it partially with every profit target reached. It's called partial profit taking or half profit targets and is widely used by traders.
Here's a simple example of a trade with partial profit taking. A trader buys 1 lot of EUR/USD at 1.3330 and sets stop-loss to 1.3300, and take-profit to 1.3400. Additionally, he intends to close a half of the position when the rate reaches 1.3365 and move the stop-loss up to break-even at 1.3330. This way, when EUR/USD reaches 1.3365 rate, the trader books 35 pips on 0.5 lot ($17.50) and is now in a risk-less trade with a chance to win $35.00 more. If the price then retraces to 1.3330, the new stop-loss is triggered and the trader's total profit is $17.50; if the price goes all the way to 1.3400, the take-profit on the remaining 0.5 lot is triggered and the overall gain for this position becomes $52.50. If partial profit taking wouldn't be used in this case, there would be only two possible outcomes for this position: either $30.00 loss or $70.00 profit. That's just an example — in reality partial profit taking can be more complex with more than one intermediate target level.
So is the partial profit taking a viable Forex trading technique? Does it improve the overall trading record? Does it provide any other advantages to the trader? You'll find different opinions on this matter in trading related sources. Some successful traders promote this method, while others call it dangerous (Van K. Tharp does so in his Trade Your Way to Financial Freedom on p. 265, Chapter 10 — How to Take Profits — What to Avoid). In this article I will try to demonstrate the actual difference in the impact on the account's end balance when using partial profit taking compared to conventional profit taking.
Random Walk Market
For our first model let's look at the random walk market, i.e. the one where the price changes are completely random and there's an equal probability for going up and down at any given moment. That means that our trading strategy doesn't have an edge — it can't have an edge in a completely random market. The trading scenario for conventional profit taking and for half profit targets with an edge-less trading system is demonstrated below:
Position is open at entry level and, obviously, has 0 profit at that level. If our trading system has no edge, there's the same chance for going up as for going down. That means that if we use simple profit taking (with one target), we have 0.5 probability of reaching point B (20 pips profit) and 0.5 probability of reaching point D (20 pips loss), resulting in the trade expectancy of $0.00 (20 × 0.5 + (-20) × 0.5 = 0). Now, if we use the partial profit taking with one half profit target, we have the following probabilities at play:
- The chance to reach level A is twice as high as to the one to reach level D — 0.66 vs. 0.33, because it's located twice closer. That results in the intermediate trade expectancy of -$3.33 (5 × 0.66 + (-20) × 0.33 = -3.33). Remember that we close only half of our position at level A, so we book only 5 pips of profit instead of 10.
- If we reach level A, we now have to calculate the probabilities of reaching level B or going back down to zero level (we also move our stop-loss up to break-even level). Probability to reach level B from level A is the same as of reaching zero level — 0.5. The trade expectancy then is $3.33 ((10 × 0.5 + 0 × 0.5) × 0.66 = 3.33)
- The resulting trade expectancy of the partial profit taking method is -$3.33 + $3.33 = $0.00 — the same as with the one-target method.
So does it has any advantages or disadvantages with the edge-less trading systems? Only the minor ones. Partial profit taking helps to smooth the account balance curve volatility. It also has higher execution risks because it involves more trades per position. Additionally, it's providing a sense of psychological comfort to a trader, who is now making more profitable trades, albeit at a cost of decreasing their average size.
Trading Strategy with Edge
Now, let's get back to the real world, where traders assume that their Forex trading systems have some sort of an edge compared to entering the market blindly. For our second model to be more demonstrative, let's assume that our system has a really nice edge over the market — the price at our entry point has a double chance of going in our direction compared to that of going in the opposite direction. So how does our trade expectancies fare with two different profit taking methods? Considering the same chart as above, we have the following trade expectancy for a single profit target method: $6.66 (20 × 0.66 + (-20) × 0.33 = 6.66). As for the partial profit taking technique, we have the following probabilities:
- The chance to reach level A is now four times higher than to reach level D — 0.8 vs. 0.2, because we have an edge and also because it's located twice closer. Our intermediate trade expectancy then is $0.00 (5 × 0.8 + (-20) × 0.2 = 0).
- Now, at level A, we have probability of 0.66 to reach level B and probability of 0.33 to reach zero level. The resulting trade expectancy then is approximately $5.33 ((10 × 0.66 + 0 × 0.33) × 0.8 = 5.33).
- Calculating the resulting trade expectancy of the partial profit taking method gives us $0.00 + $5.33 = $5.33 — result, which is $1.33 worse than the one attained with a single take-profit level.
It turns out that when we use this method of profit taking with a better-than-random entry system, the minor differences are accompanied by a huge disadvantage for a trader — decreased trade expectancy.
According to the above calculations, the bigger is the edge of your Forex trading system, the bigger is the advantage of the conventional single profit target method over the partial profit taking method. That means that the former should be used only if you don't believe that your market entry system can fare better than if you'd be trading completely randomly. Even then, the partial profit taking system offers no significant advantage compared with the common single take-profit method.
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