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 technique’s they are using have a distinct “edge” for the time frame they are trading (short-term, swing, long-term, etc.).
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, you need 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.
If a particular entry signal generates a move in which the average – maximum good movement is higher than the average – maximum bad movement, this will show that a positive edge does exist. If it were the other way around, the maximum bad movement 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. 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.
A few more steps are necessary to turn this into a reliable way of measuring the edge for entry signals. First is that 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, CTA’s so that they can compare the averages and equate them by using the Average True Range or ATR. To isolate the market action of entries over various markets, it is helpful to be able to compare the price behavior of a specific entry signal using different time frames. Use the following formula below:
- Compute the MFE and MAE for your specified time period.
- Divide each (MFE & MAE), by the Average True Range (ATR), at the time of entry to adjust for volatility.
- Sum up each of these values separately and then divide 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 calculates the MFE and MAE for ten days, including the day of entry, an R50 uses 50 days, etc.
Applying the Ratio
This ratio is used by CTAs 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, and if they ran more trials, the numbers would get closer to 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 with the Donchian Trend System
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 be thinking that the R – ratio should be much greater with a positive edge on your entry signal. This is true, but what you need to keep in mind is 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 subsequent to the entry signal. The ratio definitely changes over varying numbers of days, and this is one of the reasons trading breakouts can be difficult psychologically.
If you follow or have your own Entry method, you should take the time necessary to do the research into 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 in calculating or going over different entry strategies that may fit you, send us an email or feel free to call one of our risk management specialist directly.