When a CTA or Money Manager is testing or back-testing their entry signals, one of the most important aspects they look at is if the techniques they are using have a distinct “edge” for the time frame they are trading (short-term, swing, long-term, etc.).
Understanding MAE and MFE
Positive price movement is when the market goes in the direction of the trade. In other words, when you buy, it’s good when the market keeps going up and bad when the market moves lower. When you sell short, it’s good when the market moves down and bad when the market moves against you and goes higher. Also, it would be best to consider those cases when you buy, and the price initially goes down, which is bad for the trade, and then reverses and goes above your entry price and moves higher.
In trading, a move in the bad direction is referred to as “maximum adverse excursion,” and the maximum move in a good direction is referred to as “maximum favorable excursion” (MFE). You can use these two components to measure the “edge” of an entry signal directly.
Suppose a particular entry signal generates a move in which the average – maximum good movement was higher than the average – maximum bad movement. In that case, this will show that a positive edge does exist. If it were the other way around, the maximum bad movement is higher than the maximum good movement, then it would show that a negative edge existed. This isn’t necessarily a bad thing, as you could use this “negative edge” entry signal to take the “opposite” trade – (Mean Reversion Strategies).
Random entry occurs when the MAE and the MFE are about the same. So, for example, if you flipped a coin and heads represented buying and tails represented selling, one would expect after using this type of entry method that the MAE would be equal to the MFE.
Equating Price Movements Across Different Markets
A few more steps are necessary to make this a solid way of measuring the edge for entry signals. First, you have to have a way to equate price movement across different markets, and second, you need a way to determine the period over which you want to measure the average- MFE and the average MAE.
To organize the MFE and MAE across different markets, CTAs can compare and equate the averages using the Average True Range or ATR. It is helpful to compare the price behavior of a specific entry signal using different time frames to isolate the market action of entries over various markets. Use the following formula below:
- Compute the MFE and MAE for your specified period.
- Then, divide each (MFE & MAE), by the Average True Range (ATR), at the time of entry to adjust for volatility.
- Sum up these values separately and divide them by the “total # of signals” to get the “average volatility-adjusted MFE and MAE.
- The ratio is the “average volatility-adjusted MFE divided by the average volatility-adjusted MAE.
To define the time frame used, use the # of days you used in the description of the ratio to indicate the # of days over which the component MFE and MAE were computed. For example, an R10-ratio measurement computes the MFE and MAE for ten days, including the day of entry. An R50 uses 50 days, etc.
CTAs use this ratio to measure whether their entry signal has a valid edge. For example, if they tested a random (coin-flip entry), they would probably be looking at results like an R5- ratio of 1.01, an R10- ratio of 1.005, and an R50 – ratio of 0.997. These numbers are very close to 1.0; if they ran more trials, they would reach 1.0. This is the case because the price is just as likely to go in their direction as it is against them after they enter a trade based on random entry.
Example of Measuring Edge of an Entry Signal
To give you an example of this, use the Donchian Trend System. The entry rules for this system are simply that one should “buy” when the price exceeds the highest high of the previous 20 days and sell short when the price goes lower than the lowest low of the previous 20 days. The results are as follows. The R5- ratio for this sample was 0.99, and the R10- ratio was 1.0. You might think the R – ratio should be much greater with a positive edge on your entry signal. This is true, but you need to remember that the Donchian breakout system is a medium to long-term trend-following system, so its entry needs to have an edge over these time frames and not the short term. The R70 – ratio for entry is 1.20, which means that trades are taken in the direction of a 20-day breakout move on average 20 percent farther in the direction of the breakout than they do in the opposite direction when one looks at price movement in the 70 days after the entry signal. The ratio changes over varying days, which is one reason trading breakouts can be problematic psychologically.
If you follow or have your entry method, you should take the time necessary to research what type of “edge” your entry system has or doesn’t have in the markets over the time frame you trade, per the above. If you do, I think you’ll be amazed at some of the results you may find. If you need assistance calculating or reviewing different entry strategies that may fit you, email us, or feel free to call one of our risk management specialists directly.