What Are Take Profit Orders?
A take profit order is a type of limit order placed by a trader or investor to automatically close out a profitable position once a specific price level is reached. As a crucial component of order types in financial markets, take profit orders are designed to lock in gains and remove the emotion from the decision-making process of when to exit a trade. They are a common tool in trading and are often used as part of a broader risk management strategy, ensuring that predetermined profit targets are met.
History and Origin
The concept of automated order execution, which underpins modern take profit orders, emerged with the broader evolution of electronic trading systems. Early forms of automated trading can be traced back to the mid-20th century, with figures like Richard Donchian in 1949 exploring rule-based systems to initiate trades automatically when predetermined market conditions were met. While Donchian's methods initially required manual charting, the foundation for autonomous execution was laid. The true shift began in the 1970s and 1980s with the increasing computerization of financial markets and the advent of electronic trading platforms like NASDAQ.5,4 This era saw the development of "program trading," where algorithms executed baskets of stocks based on predefined signals.3 These technological advancements paved the way for individual investors and institutional traders alike to employ sophisticated order types, including take profit orders, to manage their positions.
Key Takeaways
- Take profit orders are automated instructions to close a profitable trade at a specified price.
- They help lock in gains and prevent emotional decisions from affecting trade exits.
- These orders ensure discipline in an investment strategy by predefining exit points.
- Take profit orders are a fundamental aspect of modern electronic trading and portfolio management.
- They are contingent orders, meaning they only execute if the market price reaches or surpasses the specified take profit level.
Interpreting Take Profit Orders
A take profit order is interpreted as an instruction to sell an equity or other asset when its price rises to a specified level, or to buy an asset back if short, when its price falls to a specified level, thereby securing a profit. For long positions, it is set above the current market price, and for short positions, it is set below. The order's placement is typically informed by analysis, such as technical analysis of chart patterns, resistance levels, or valuation metrics derived from fundamental analysis. The interpretation involves understanding that the order will only activate if the market price is favorable enough to reach the designated profit target. If the price never reaches this level, the order will not execute, and the position remains open.
Hypothetical Example
Consider an investor, Sarah, who buys 100 shares of XYZ Corp. at $50 per share, believing the stock will appreciate. To secure her profits if the stock performs as expected, she immediately places a take profit order at $55 per share.
- Initial purchase: 100 shares of XYZ Corp. at $50.00.
- Take profit order set: Sell 100 shares of XYZ Corp. at $55.00.
If XYZ Corp.'s stock price rises to $55.00 or higher, Sarah's take profit order will automatically trigger, and her 100 shares will be sold at $55.00 or better, locking in a $5.00 per share profit. This action removes the need for Sarah to constantly monitor the stock price, ensuring her desired profit is realized without hesitation or emotional influence. The automated execution helps manage her exposure to volatility.
Practical Applications
Take profit orders are widely used across various segments of financial markets by different types of market participants. Individual investors often use them to manage speculative positions in stocks or cryptocurrencies, allowing them to participate in upward movements while safeguarding gains. Professional traders, including those in proprietary trading firms and hedge funds, integrate take profit orders into complex algorithmic trading strategies to execute trades at precise levels and manage large volumes of positions. This enables efficient asset allocation and scaling out of positions. Regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), provide guidance on various order types and their proper use, emphasizing the importance of understanding their mechanisms for effective risk management.2 The proliferation of electronic trading systems has made such orders accessible, contributing to the speed and efficiency of modern markets.1
Limitations and Criticisms
While take profit orders offer significant advantages in securing gains, they also come with limitations. One primary criticism is that they can prematurely close a position, potentially cutting short larger profits if an asset continues to rise significantly beyond the take profit level. This can lead to what is known as "leaving money on the table." Furthermore, in highly volatile market conditions, the specified take profit price may not be precisely achieved, resulting in slippage—the execution of an order at a price different from the intended one. This can occur if market liquidity is low or if prices move very rapidly through the target level. Automated orders, including take profit orders, are part of the broader ecosystem of algorithmic trading, which has faced scrutiny for potentially intensifying market swings or leading to "flash crashes" due to their rapid, interconnected execution. While individual take profit orders typically do not cause such broad market events, their widespread use as part of automated strategies underscores the importance of robust systems and careful parameter setting by a broker or trader.
Take Profit Orders vs. Stop-Loss Orders
Take profit orders and stop-loss orders are often used in conjunction as complementary tools in a trader's arsenal, but they serve opposite functions. A take profit order is designed to lock in gains by selling an asset once it reaches a predetermined profitable price. Its purpose is to realize a positive return on an investment. In contrast, a stop-loss order is designed to limit potential losses by selling an asset if its price falls to a specified level. While both are contingent orders that automate exit strategies, the take profit order aims to capture an upside, and the stop-loss order aims to mitigate a downside. They represent two sides of comprehensive risk management.
FAQs
What happens if the price never reaches the take profit order?
If the price of the asset never reaches the specified take profit level, the order will not be executed. The position will remain open, and the investor will need to decide whether to adjust the order, wait longer, or close the position manually.
Are take profit orders guaranteed to execute at the exact price?
No, take profit orders are not always guaranteed to execute at the exact specified price. While they are designed to be filled at the limit price or better, rapid market movements or insufficient liquidity can lead to "slippage," where the order is filled at a slightly different price than intended.
Can take profit orders be modified or canceled?
Yes, most trading platforms allow investors to modify or cancel take profit orders as long as they have not yet been executed. This flexibility is important for adapting to changing market conditions or investment strategy adjustments.
How do take profit orders differ from market orders?
A market order is an instruction to buy or sell an asset immediately at the best available current price. It prioritizes immediate execution over price certainty. A take profit order, however, is a contingent limit order that only executes once a specific, more favorable price is met, prioritizing price over immediate execution.