Summary of "Why fixed take profits destroy returns (and what to do instead) (EP 41)"

Summary

The video discusses why fixed take profit (TP) strategies commonly used by traders can significantly harm trading performance and offers alternative approaches, especially in systematic trading and strategy design.

Key Finance-Specific Content

Fixed Take Profits: Issues and Risks

Common practice: Traders often use fixed take profits such as 3R, fixed points (e.g., 5 points), or fixed percentage gains (e.g., 2%).
Main problem: Fixed TPs often leave substantial profits on the table and reduce overall strategy profitability.
Overfitting risk:
- When backtesting, traders test multiple fixed TP values (e.g., 1 to 20 points) to find the “best” one.
- This leads to overfitting on historical noise, causing poor live performance.
- Parameter sensitivity testing requires sufficient data; testing on limited data (e.g., 30 days) is unreliable.
Misalignment with market dynamics:
- Fixed TPs are arbitrary and do not reflect evolving market conditions or fair value estimates.
- Particularly problematic for mean reversion strategies where fair value is dynamic.
Capping profits:
- Fixed TPs cap potential gains, especially damaging in trend-following strategies.
- Trend-following relies on letting winners run for outsized returns (e.g., 10R winners).
- Fixed TPs increase win rate superficially but reduce the average return and weaken the strategy.
Contradiction in trend models:
- Trend following bets on price persistence and divergence.
- Fixed TP signals exit prematurely, opposing the core strategy signal.

Alternative Approaches to Take Profits

Dynamic, signal-based exits:
- Use trailing stops or volatility-based stops rather than fixed points.
- Exit only on opposite signals (e.g., price closes below trailing stop).
- Allows letting profits run naturally and captures positive skew in returns.
Composite indicators:
- Instead of relying on a single indicator (e.g., Bollinger Bands), use a combination of momentum, trend, and volatility indicators to determine exit points.
- Exit decisions based on a composite momentum score or exposure signal.
Fair value models:
- For mean reversion, use dynamic fair value estimates (moving averages, volatility bands, Bollinger Bands) to set adaptive profit targets.
- Recognize that fair value is not static and adjust exit points accordingly.

Portfolio Construction and Risk Management: Delta Neutral Strategies

Delta neutral / market neutral approach:
- Construct long-short portfolios with net zero exposure to the market.
- Example: Long top N equities and short bottom N equities to neutralize market beta.
- Dollar exposure is different from net exposure; focus is on neutralizing directional risk.
Benefits:
- Reduced drawdowns during volatile or bearish markets (e.g., 2008, 2020).
- Suitable for choppy or downward trending markets like recent crypto conditions.
- Provides insurance-like protection and smoother returns.
Trade-offs:
- Typically underperforms absolute returns in strong bull markets due to lack of market beta.
- Complements other strategies that capture upside in bull markets.
Multi-strategy approach:
- Running multiple strategies (trend following, mean reversion, delta neutral) helps diversify risk and smooth returns.
- Allows traders to tolerate periods of underperformance in some strategies while others outperform.

Additional Points

Trading should be based on strategic edges and market understanding, not arbitrary monetary goals (e.g., wanting to make $200 per trade).
Fixed take profits provide psychological comfort but at the cost of long-term profitability.
Consistency and adaptability in strategy design are critical for live trading success.

Tickers, Assets, Instruments Mentioned

Futures contracts: Example used for fixed take profit testing.
Equities: Microsoft (MSFT) and Apple (AAPL) used as example pair for mean reversion.
Crypto: Mentioned in context of delta neutral strategies.
Trend following and mean reversion models: General strategy types discussed.
Indicators: Bollinger Bands, moving averages, Average True Range (ATR).

Methodology / Framework for Exits and Portfolio Construction

Avoid fixed take profits:
- Do not set arbitrary fixed profit targets.
- Avoid overfitting by limiting parameter tuning and using sufficient data.
Use dynamic, signal-driven exits:
- Trailing stops based on volatility or opposite signals.
- Composite momentum/trend indicators for exit timing.
- Fair value models for mean reversion exits.
Delta neutral portfolio construction:
- Select long and short assets to neutralize market exposure.
- Maintain net zero directional exposure.
- Use this to reduce drawdowns and smooth returns in volatile or bearish markets.
Multi-strategy diversification:
- Combine trend following, mean reversion, and delta neutral strategies.
- Accept varying performance cycles for more consistent long-term returns.

Key Numbers & Timelines

Fixed take profit examples: 3R, 5 points, 2%.
Parameter sensitivity testing range: 1 to 20 points.
Trend following example: 10R winners critical for profitability.
Data sufficiency caution: 30 days of data insufficient for reliable parameter testing.
Historical crises referenced: 2008 financial crisis, 2020 market crash.

Recommendations & Cautions

Avoid fixed take profits to prevent overfitting and profit capping.
Use dynamic, adaptive exit strategies aligned with the underlying market signals.
Implement trailing stops or composite indicator-based exits.
Consider delta neutral strategies to reduce market risk and drawdowns.
Diversify across multiple strategy types to balance risk and returns.
Beware of the psychological comfort fixed take profits provide, as they can reduce real profitability.
Ensure adequate data and robust out-of-sample testing to avoid overfitting.

Disclaimers

The discussion is educational and not financial advice.
Strategy performance can vary; no guarantee of profits.
Market conditions and models evolve; continuous adaptation is necessary.

Presenters / Sources

Two unnamed presenters discussing systematic trading strategies.
One references conversations with traders and a podcast featuring a trend following manager.
Examples and explanations are drawn from personal experience in futures, equities, and crypto markets.

End of summary.