Best- and worst-case scenarios

Maximum favorable excursion and maximum adverse excursion were terms coined by John Sweeney and detailed in his book, Campaign Trading: Tactics and Strategies to Exploit the Markets (Wiley Finance Editions, 1996). MFE is the largest open profit attained during a trade. The MAE is the largest open loss while in a trade. For example, it is a 45-minute Euro/U.S. dollar (EUR/USD) chart with the moving average convergence-divergence (MACD) histogram, which is the difference between the MACD line and the signal line. For illustration purposes, the chart shows an entry based on a simple momentum strategy: Hold a long position if the histogram bars are rising, and hold a short position if the histogram bars are falling. When the histogram bars change direction, the trade is exited.

At point A, the histogram bar turns up for the first time, so the trade is to go long at 1.2798 and exit when the histogram bar turns down (point B, 1.2828) — a 30- pip gain. The trade’s MFE was 47 pips and the MAE was 9 pips. In this example, the profit was 30 pips, which means approximately one-third of the open profit was lost before the trade was exited.

Reviewing positions this way reveals that trades fall into one of three categories. It consists of the type of trades everyone likes — when the position becomes profitable immediately and there is no open loss (MAE), and the trade is exited near the highest open profit (MFE). It trades go into negative territory, but recover and are closed out for profits. It trades might be profitable at first and then reverse to become losses, or they are losses from the start and never recover.

A trading strategy can be tailored to manage risk in a more intelligent fashion by putting it in sync with typical market volatility. There are two objectives. The first is to determine the point at which trades that are likely trades can be exited sooner, but not too soon as to remove the chance of them becoming trades.

The second objective is to find a high-probability target point at which to take profits. This profit level should be a level trades reach on a regular basis. Traders can take complete profits at this point, or take partial profits and use the trend-following rule to exit the remainder of the position.

However, to perform this analysis, the trading strategy must consist of set procedures — as opposed to discretionary procedures, which cannot be back tested. Don’t think you will know when to pick a “good” entry signal vs. a “bad” one. If you think you will be able to determine in real time trading which buy setups will work and which won’t, you’re setting yourself up for emotional turmoil and poor decision making.

This analysis is best applied to trading strategies that reverse when an entry signal in the opposite direction occurs. If the strategy uses a predetermined profit limit, for example, the MFE analysis will be cut short.