In active portfolio management, mastering stop-loss and take-profit orders is essential to optimize the risk/reward ratio. These tools allow you to limit losses and secure gains automatically, thereby reducing the emotional impact on trading decisions. This article details methods for placing stops, notably comparing the stop based on the Average True Range (ATR) with the fixed stop, analyzes the importance of a minimum risk/reward ratio of 1:2, and explores the use of trailing stops. Finally, a backtest on the S&P 500 index illustrates the comparative effectiveness of these approaches.
Fixed stop versus ATR-based stop: definitions and operation
The fixed stop corresponds to a predetermined price level, at a constant distance from the entry, for example a stop placed 2% below the purchase price. This method is simple but does not take market volatility into account.
The ATR-based stop uses the Average True Range, an indicator measuring the average volatility over a given period (usually 14 days). The stop is placed at a multiple of the ATR (for example 1.5 x ATR) from the entry price, thus dynamically adjusting protection according to market conditions.
The ATR is calculated as follows:
ATR = Moving average over N days of (max(High - Low, |High - Previous Close|, |Low - Previous Close|))
This method helps avoid premature exits due to normal volatility while protecting against abnormal price movements.
Minimum risk/reward ratio of 1:2: why it’s crucial
The risk/reward ratio (risk versus potential gain) is a fundamental indicator for the profitability of a strategy. A recommended minimum ratio is 1:2, meaning the potential gain must be at least twice the maximum acceptable loss.
For example, if the stop-loss is placed 1% below the entry price, the take-profit must be positioned at least 2% above. This ratio allows compensating for a success rate below 50% while remaining profitable.
According to a study by the Autorité des marchés financiers (AMF), strategies respecting this ratio show better robustness over time, especially on European equity markets.
The trailing stop: mechanism and advantages
The trailing stop is a dynamic variant of the stop-loss, which follows the price when it moves favorably, maintaining a fixed or proportional distance (often based on the ATR). Thus, it protects accumulated gains without limiting the possibility of additional profits.
For example, a trailing stop at 1.5 x ATR will automatically move upwards if the market advances, but remain static in case of a reversal, triggering the sale as soon as the price falls below this threshold.
This method is particularly useful for capturing long trends while securing profits, reducing the impact of short-term fluctuations.
Comparative backtests on the S&P 500 index
To illustrate the effectiveness of the different methods, we conducted a backtest on daily S&P 500 data from January 2010 to December 2023 (source: Bloomberg).
Backtest parameters:
Long positions only
Entry on a simple bullish signal (20-day moving average crossing above 50-day moving average)
Stop-loss placed either fixed at 2%, or at 1.5 x ATR(14)
Take-profit set for a risk/reward ratio of 1:2
Trailing stop applied in a variant with ATR stop
Strategy
Number of trades
Success rate (%)
Average gain per trade (%)
Average loss per trade (%)
Gain/loss ratio
Total performance (%)
Maximum drawdown (%)
Fixed stop 2% / Take-profit 4%
120
48
4.0
-2.0
2.0
45.6
12.3
ATR stop 1.5 x ATR / Take-profit 3 x ATR
115
52
5.2
-2.4
2.17
58.9
10.1
ATR stop + trailing stop / Take-profit 3 x ATR
110
55
5.8
-2.1
2.76
67.3
9.4
Sources: internal TradeXora calculations, Bloomberg data, period 2010-2023.
Analysis of results
The results confirm that:
The fixed stop at 2% is simple but less effective, with a higher drawdown (12.3%).
The ATR-based stop improves risk management by adapting the stop distance to market volatility, resulting in a higher average gain (5.2% vs 4.0%) and a reduced drawdown (10.1%).
Adding a trailing stop to the ATR strategy maximizes trend capture, further increasing total performance to 67.3% over 14 years, while lowering the drawdown to 9.4%.
Moreover, the success rate is higher with dynamic stops, which decreases the frequency of premature exits.
Practical recommendations for French investors
Based on the data and market literature, here are actionable recommendations:
Favor ATR-based stops rather than fixed stops, to automatically adjust protection according to volatility in the French and international markets (CAC 40, S&P 500).
Maintain a minimum risk/reward ratio of 1:2 to ensure strategy viability even with a moderate success rate.
Use a trailing stop to secure gains on winning positions, particularly on strongly trending stocks or sector ETFs.
Systematically perform backtests on the relevant asset before implementation, taking into account the specifics of the French market and transaction costs.
Regularly monitor volatility via the ATR, as market conditions evolve and stops must be recalibrated accordingly.
Conclusion
Rigorous management of stop-loss and take-profit orders is a major lever to optimize investment performance by reducing losses and maximizing gains. ATR-based stops, combined with a minimum risk/reward ratio of 1:2 and the use of trailing stops, demonstrate superiority on the S&P 500 over more than ten years, with significantly higher gains and lower drawdowns.
For French investors, adopting these practices improves the robustness of strategies in a volatile and often uncertain environment. Discipline in stop placement and a methodology based on objective indicators like the ATR are key elements to navigate financial markets effectively.
