Trading systems are designed to capitalize on market opportunities by executing trades based on predefined rules. The efficacy of these systems is often measured by their profitability and risk management capabilities. Two essential metrics that aid in this assessment are Maximum Adverse Excursion (MAE) and Maximum Favorable Excursion (MFE). Understanding these concepts is vital for traders and researchers aiming to enhance the robustness and profitability of trading strategies.

Definition and Significance

• Maximum Adverse Excursion (MAE): MAE is defined as the maximum loss encountered by a trade while it is open before it is closed for a profit or a loss. It measures the worst-case scenario in terms of drawdown during the lifespan of a trade. MAE is a crucial metric for understanding the risk associated with a trading strategy, as it provides insight into the potential downside that traders might experience. By analyzing MAE, traders can better understand the risk profile of their trading strategies. High MAE values may indicate that the strategy is exposed to significant risks, prompting a review of stop-loss settings and position sizing. Conversely, lower MAE values suggest a more controlled risk environment.
• Maximum Favorable Excursion (MFE): MFE, conversely, is the maximum profit achieved by a trade while it is open, before it is eventually closed. MFE helps traders assess the peak performance of their trades and understand the best-case scenarios during the trade’s duration. Analyzing MFE can reveal opportunities where profit-taking strategies might be optimized. MFE analysis aids in identifying the potential maximum gains that trades could achieve. This information can be used to optimize exit strategies, ensuring that profits are maximized without leaving substantial gains unrealized.

Example

Consider a trading system that executes multiple trades over a period of time. The following example demonstrates the calculation and interpretation of MAE and MFE:

Trade 1:

• Entry Price: $100
• Exit Price: $110
• Lowest Price During Trade: $95 (MAE)
• Highest Price During Trade: $115 (MFE)

Trade 2:

• Entry Price: $200
• Exit Price: $190
• Lowest Price During Trade: $185 (MAE)
• Highest Price During Trade: $210 (MFE)

For Trade 1, the MAE is $5 (from $100 to $95), and the MFE is $15 (from $100 to $115). For Trade 2, the MAE is $15 (from $200 to $185), and the MFE is $10 (from $200 to $210).

MAE and MFE are indispensable metrics in the study and development of trading systems. They provide vital insights into the risk and reward characteristics of trades, enabling traders to refine their strategies for better performance. By incorporating MAE and MFE analysis, traders can achieve a more nuanced understanding of their trading systems, leading to improved risk management and profit optimization. Future research could focus on integrating these metrics with advanced algorithmic trading strategies to further enhance trading outcomes.

References

• Chande, T.S. (1997). Beyond Technical Analysis: How to Develop and Implement a Winning Trading System. Wiley Finance.
• Schwager, J.D. (2012). Market Wizards: Interviews with Top Traders. Wiley.