OK, Profit Targets. You’ll tell me this is the anti-thesis of Trend Following, with one of its strongest mantra being:
Cut you losses short, let your winners run…
Indeed, Trend Following relies on a few positive outlier trades (from a fat-tailed distribution) to derive most of its gains. Stopping trades from running as high as they could might not sound like a good idea.
But it is also a tempting idea to try and exit the trade before the typical Trend Following reversal, if only to try and smooth the equity curve.
I know about it: I have been there before with my discretionary trading. It is so easy to fall into these two traps (let your losers run and cut your winners short!). That is one of the reasons I decided to trade in a systematic fashion.
Anyway, I digress… Despite hearing many times over that take-profit orders are detrimental to a Trend Following strategy, I wanted to test this for myself (always double-check your sources…).
Profit Target Test
I ran a quick test using a dual Moving Average cross-over system (the medium-term one from the State of Trend Following report)
The test involved stepping through two different parameters:
- Target profit level (expressed in multiples of entry ATR).
- Percentage of position to sell upon hitting the target profit.
There are three main cases driven by the position reduction percentage:
- 0% – no profit target: the position runs as per its normal course (ie. normal system exit signal)
- 100% – position is fully exited at the profit target level
- a value between 0% and 100%: position is partially exited at the profit target level
When partial take-profit orders are executed (eg cut 50% of position after price has risen/fallen by 6x ATR), the rest of the position gets liquidated when price rises/falls by another ATR-multiple.
Below are the results in graphical 2D and 3D form. Each surface chart represents the metric output (CAGR or MAR) for each stepped parameter pair.
This is probably just one more example of the benefits of letting winners run.
Of course this is just a one-off, very simplified example and should not necessarily be used for generalisation… But it should not be a surprise that Trend Following’s performance is negatively impacted when breaking one of its fundamental principles….
There might be still some benefits in trying to identify potential reversal points – as is sometimes being advertised by some CTAs (BlueTrend comes to mind) – in order to cut positions early. But I believe the approach needs to be more specific/sophisticated than a blanket ATR-multiple Take-Profit order.
EDIT: Updated Test Results
I realised after writing the post that there was a “trend” in the results with performance seemingly improving as the profit target moved higher. I decided to complete the test by running it all the way to 40x ATR as profit target. Below are the results:
We can see some small pockets of over-performance on areas outside of the 0%/no profit-taking orders, but given the variability within the results, they may well be down to random variation…