Posted on Quantopian.com
Profit (and loss) for a single trade are closely tied to the type of strategy being traded. The two primary strategy types you’ll find on most technically based platforms are momentum and ranging. The primary types of momentum strategies are breakout and trend following where you’re betting on a long run. There are many types of range strategies, but statistical arbitrage is the biggest subgroup. With a stat-arb strat you’re trying to carve out an anomalous price move from a flurry of normal moves, whether you’re trading a single security on a bevy of technical indicators, or pairs arbitrage, or basket arbitrage you’re betting on reversion to mean. Another way to think of the two types of strategies is in momentum type, you’re buying strength and selling weakness. In stat-arb, you’re (generally) selling strength and buying weakness.
With these two types of strategies in mind you can now pick the one that you are trading and then apply the appropriate exit. When it comes to momentum strategies think “Turtle traders.” You’re willing to take lots of small losses on false momentum signals while waiting for the big kahuna to show up. So well defined stop losses are imperative. For such trading scaling in is often advised, when you’re winning, you add size. The profit target on a momentum trade is the opposite of the entry; on momentum exit signals (reversals) you’ll be scaling out of your position, knowing that you might be getting faked out on some of the signals. A momentum profit target is often an order of magnitude larger than your stop loss. You’ve heard the saying “let your winners run” no doubt. This only works for momentum strategies. Cutting short a winning momentum trade, as if it were a stat-arb trade, is a common mistake.
For the various stat-arb style strategies profits are much smaller and may even be equal to your stop loss, as long as your technique leaves you with a high win to loss ratio. Volatility is an important aspect to most arbitrage strategies. If you’re looking to capture reversion to mean you need to know how far away the mean is, usually in ATR units. On the entry to a common arb strat you’ll calculate the probability of price moving against you x ATRs vs the probability of price moving in your favor y ATRs. Knowing these levels prior to entry, or just after entry, is important to calculate your risk. Traders often talk about reward to risk ratio. A 2 to 1 ratio, generally for stat-arb or swing trading, is a standard. Lose 1 ATR and win 2 ATRs is one way to look at this.
Swing style strategies are what I think to be a blend of momentum and arbitrage. There may be a bit of mis-pricing that you’re trying to capture in addition to over all market momentum. In such trades, what are called measured moves are often useful. Ways to measure a potential profitable move could be taking the height of prior similar moves, either up or down, Fibonacci levels, target support and resistance levels, or just plain ‘ol technical exhaustion.
The key to establishing profit targets is knowing what strategy type you’re trading, your expected win/loss ratio, and the amount of risk you’re willing to take on any one trade.