Prior to executing a trade, I tend to believe that one should consider the entry from the perspective of Risk-To-Reward (RR) ratio. Some say that a trade must have a minimum RR of 1.5x or even 2.0x. In determining the RR ratio, one must know the assumptions for Target Price / Entry Price / Stop Loss, of which the RR is defined as follows:
RR = (Target Price – Entry Price) / (Entry Price – Stop Loss)
The key question is how do I determine my Target Price (TP)?
There are many different views in determining TP. Personally, I tend to look at few possible approaches (note: there is definitely no hard and fast rule).
My Approach 1: What is significant previous support / resistance / peak / trough?
First of all, look at higher timeframe chart (e.g Weekly) and look for previous significant resistance / support / peak / trough levels. But how do you define significant? Visually you may be able to see them. Look at corresponding volume as well. For example, looking at the Tadmax weekly chart below, assuming entry was made in Jul 2019, I will consider possible TP based on significant past resistance / support / peak / trough levels. As per the chart below, we may see possible TP points at $0.375, $0.47 and even $0.55 as these represent significant past support / resistance zones.
My Approach 2: Price Objective
This depends on the security’s chart pattern. Tadmax’s recent chart pattern looks like a Rounding Bottom. Assuming this is the case, the measure rule for Rounding Bottoms uses the height of the cup from the bottom to the left or right cup. Add the height to the breakout price – usually the right cup lip or break of the trendline. For more conservative measure, may use 50% of the projected height. In this case, the base case price objective is $0.40 (breakout at $0.30) and more conservative TP of $0.35 (based on 50% of $0.10).
For price objective, do benchmark the sanity of this price objective against potential resistance and support zones of the security.
My Approach 3: Return Driven
For each trade, one may set a minimum return on investment (ROI). For example, I may want to set a minimum ROI of at least 15-20% from each trade or even based on RR ratio. Once my ROI threshold has been met, I may choose to divest up to 50% of holdings and continue to hold the rest of holdings until there are ‘significant signals’ to indicate that a bearish trend is about to form. One should consider implementing a trailing stop to ensure that the minimum ROI can still be achieved with the future divestment of the remaining 50%.
This approach may be useful when the entry price represents the highest price in the historical price of the security. As per QL chart below, assuming an entry in early 2014, one does not have any past historical reference points of potential resistance points to plot the target prices. Hence, a return driven approach may be useful to plan the Target Price. In the QL case below, i would have exited 50% of my holdings (once my minimum ROI has been achieved), whilst I will divest the remaining 50% upon concrete formation of sell signals or price has fallen below my trailing stop.
My Approach 4: Fundamentals & Target Price
Any negative change in company / industry fundamentals (based on latest quarterly results / latest developments) – I will sell. Or the Company has been trading at very very high valuation multiples, I will consider to dispose it off. One may also look at the movements of insiders / management / substantial shareholders to gauge potential future reversals. Last but not least, do benchmark against the average target price / recommendations set by the analysts.
Post is not an investment advice or endorsement. Please refer to General Disclaimer of this blog.