To flesh out these trade-offs, it is beneficial to look at how stop-loss width affects portfolio results when other variables are held constant. In particular, consider a straightforward long-only trend entry model applied to a broad stock index. Positions are opened when prices cross a moving average. The position size is kept constant while the stop loss thresholds vary from very narrow to relatively high levels.
Using the each day open, high, low, and shut prices of the S&P 500 (SPX) as a knowledge source, I simulate 500 investors entering at random times (2000-2005) and compare the outcomes under different stop loss widths and take profit targets (15-30%). Each curve summarizes the common results of all investors (Figure 1).
The goal just isn’t to discover an optimal trading rule or to maximise historical returns. Instead, the aim is to look at how stop loss width structurally impacts win rates, payout ratios and cumulative capital growth.
As stop losses expand, win rates increase. Trades are given more room to soak up short-term disruptions, thereby avoiding premature exits.
Figure 1: Win rate as a function of stop loss width
