April 7

Maximum Adverse Excursion: What Does It Mean?

Last Updated on 7 April, 2022 by Samuelsson

When we trade, the price often goes against our position before turning to move in our favor and probably make profits. By studying how far the price usually goes against our position before moving in our favor, we can ascertain our maximum adverse excursion. But what does this mean in trading?

In this post, we will be discussing maximum adverse excursion under the following subheadings.

• What is Maximum Adverse Excursion
• How to analyze price fluctuations for trading management using MAE

The maximum adverse excursion, also known as the maximum drawdown of an open position, is the farthest the price has moved against your position during a trade before returning to move in your favor. You get the MAE over a series of trades by reviewing your trades to know how the price usually reacts after you enter a trade.

Specifically, maximum adverse excursion shows the least price your asset reached during a long trade and the highest price during a short trade. The concept was developed by John Sweeny as a statistical system to measure drawdowns in an open trade, which can be used as a basis for establishing the right stop loss level.

Adverse execution is the negative price movements in an open position. For instance, if you opened a long position at \$25 and the asset’s price dropped to \$15 and eventually rose to \$50 before you closed the trade, the adverse excursion for that trade would be \$25 minus \$15, which is \$10.

But since the  MAE is a statistical metric, you have to review a series of trades to find the right value. For example, if in a series of five trades, you recorded 10, 12, 11, 8, and 17 as adverse movements, the MAE would be 17.

Please note that for a trade where the price never moved in the losing direction, the adverse excursion is zero. For instance, if the price of a long trade was always higher than the entry price or the price of a short trade was always lower than the entry price all through the duration of the trade, the adverse excursion is zero.

The MAE can also be expressed as a percentage. For example, a long trade with an entry at \$100 and the lowest price of \$94 during the duration of that trade would give you an MAE value of \$6. So if your stop-loss is placed at \$90, then your MAE can be expressed as 60%. Knowing the MAE on your trades can enable you to improve your trade entry and stop loss.

In the same vein, you can apply the OHLC logic to your short winning positions. In the case of your short trades, the difference between your “Open” and “High” is your MAE and the “Low” is how far the trade went in your favor and again the “Close” is your exit / take profit somewhere between your “Open” and “Low” prices.

Maximum adverse excursion vs. maximum favorable excursion

Apart from the MAE, there is also the maximum favorable excursion (MFE), which is another live-trade statistical metric. However, they both focus on different aspects of trading. While the MAE focuses on risk, the MFE focuses on profit. The MFE measures the largest potential profit the trade makes while it’s still open. Having good knowledge of the application of the concept of maximum favorable excursion can help you to properly place your profit target and avoid taking profits too early.

For example, let’s say your MFE for three consecutive trades are 40, 43, and 48 points. You should consider setting your profit target somewhere around 40 points. It is necessary to always observe how much the price often moves in your favor —the MFE — as it can guide your decision on knowing the points to place your profit target. If you prefer to manually take profits, your MFE can guide you as to when to close your trades in profits.

Maximum Adverse Excursion (MAE) is an important live-trade metric that can be used to review both automated and discretionary trading systems. By statistically analyzing the progression of your trades from the entry points to the exit, the MAE allows you to minimize risk so as to maximize profits. Here are the key areas the MAE can help you to improve your trading:

For each winning trade, you will need to know the Maximum Adverse Excursion (MAE) — how far the trade went against you after entering the trade and before the trade turned around and became a winning trade.  As you look at your sample of winning trades you will notice that most of them are generally profitable from the start or after only a short MAE, say 12, 15, 17, 19, and 30 points.

So, it offers you a statistically appropriate place to put your stop loss because you will now know that anything beyond that price stands only a 20% chance of turning around and becoming a winning trade.  You could also use an 85%, 90%, 95% MAE stop loss where at 85% any price beyond that will only have a 15% chance of being a winner and 10% and 5% for the 90% and 95% stop loss, respectively. But anything above 80% may unnecessarily increase the size of losers.

Making use of buy limit orders

Another essential application of the concept of the maximum adverse excursion is the use of buy limit orders. Following the scenario above, you can simply set limit orders 10 points lower once your setup occurs, instead of waiting for the price to fall by 10 points before entering with a market order.

Increasing position size without increasing risks

With the knowledge of your MAE, you can proportionally increase position size and reduce your stop loss size and still keep your risk the same. Generally, the amount of dollar you risk in a trade is given as follows:

Amount at risk = Position Size x Stop Loss Size x Unit Value of the Position Size Unit.

For example, if you are using a stop loss of 25 points initially and by entering at 10 points lower, your stop loss can then be safe at 15 points. You can increase your position size by 1.6x (since you reduced stop loss to 60% of what it’s used to be) and still be risking roughly the same amount in a trade.

Final Words

Putting it all together, the maximum adverse excursion is an important live-trade metric that helps you analyze how your trades usually progress so you can find ways to minimize risk and maximize profits.

Tags

How to Use Atr in Position Sizing (Best Way to Use Atr)

How to Use Atr in Position Sizing (Best Way to Use Atr)