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Maximum Adverse Excursion (MAE)

The Maximum Adverse Excursion (MAE) measures the potential loss or distance a trade has moved against you. Traders use the MAE to determine where to place a stop-loss order for their trading system.

Key Takeaways

  • Maximum Adverse Excursion is the furthest price movement that goes against your position.
  • The strategy allows you to evaluate the individual trades of your systems to ascertain the stop-loss price.
  • The MAE methodology is best suited for mechanical trading systems with specific entry, stop loss, and profit targets.
  • The MAE graph is depicted by plotting a scatter plot diagram showing each trade’s final profit or loss against its maximum drawdown or the unrealized loss.

Table of Contents

What Is Maximum Adverse Excursion?

Maximum Adverse Excursion or MAE is the maximum experienced unrealized or realized loss during a trade. It is a concept developed by John Sweeney, a seasoned trader and former Vice President, Diversification at SeafirstBanking Corporation.

The MAE concept quantifies how far the price has gone against you. It also allows you to evaluate the individual trades of your systems to ascertain the dollar or percentage amount at which you would fix your protective stop. We can say that MAE can analyze the effectiveness of stop placement.

An extremely low overall MAE could enhance the trader’s expectancy and the size of her winning trades by using a tighter stop. However, the stop size must be carefully adjusted because a closer stop could lead to a higher loss rate.

For long (short) trades, MAE is calculated with the difference between entry price and the lowest low (highest high) price ever witnessed during the trade.

Let’s say you take a long position on a security at $30. After that, the security’s price dropped to $10 and finally climbed to $40 before the trade closed. Hence, the Maximum Adverse Excursion MAE for this winning trade would be $20, or the difference between $30 and $10.

If the price of a long trade is usually higher than the entry point price or the price of a short trade is generally lower than the price at the entry point throughout the trade’s duration, the MAE is zero.

Take a look at this video to understand the dynamics of the Maximum Adverse Excursion.

Why Is MAE Important?

Maximum Adverse Excursion (MAE) gives a diversion from biased conjecture to statistical calculations so that traders can quantitatively define the loss point. MAE can highlight the amount of any potential loss before acting on their trading decisions.

Traders can use Maximum Adverse Excursion (MAE) to review various trading systems, whether discretionary or automated

. The MAE methodology is best suited for mechanical trading systems with specific entry, stop loss and profit targets. Conventionally, Stop and Reverse(SAR) is the best system to use with this methodology.

Besides helping you to maximize your profits and minimize your losses, here are some of the other vital areas where MAE can help you to get the most out of your trading:

Risk Management

MAE is essential from a risk management perspective to help determine the potential benefits of a protective stop. A scatter plot of maximum drawdown (MDD) for each backtested trade by final trade profit/loss. If there is an MDD level beyond which few trades ever end up profitable, it may be helpful to keep a protective stop. This may lessen some extreme losers while preserving most of the winners.

MAE’s are used for other purposes too. For example, a mutual fund may also use this metric to evaluate its trading strategy and demonstrate exposure risk.

Optimal Stop Loss Placement

For each winning trade, you need to know the Maximum Adverse Excursion (MAE) or how far the trade went against you before turning around and eventually become a winning trade. You can use the MAE price that covers nearly 70%-80% of your winning trades. This will become the stop-loss that you can use to modify your system. Thus. The MAE helps you to use the optimal stop loss that doesn’t stop out immediately and also minimizes the size of losses. If it’s a stop and reverse system, it can be modified to reverse the stop loss and enter a new trade in the opposite direction.

Position Sizing

Leveraging MAE knowledge, you can increase the position and size proportionately and lower your stop loss while keeping the risk the same.

While it’s easier for algorithmic traders to capitalize on MAE’s insights, discretionary traders should also leverage this valuable information.

How to Use MAE

You must begin backtesting your system by checking at least the last 30-60 winning trades per system. This is because we won’t be able to conduct statistical sampling effectively with less than 30 samples, and I recommend a lot more.

We don’t use losing trades for the MFE calculations as they likely hit a stop, which would change the MFE for the strategy.

We need to know the Maximum Adverse Excursion (MAE) for each winning trade. A scrutiny of the sample of winning trades will tell you that most of those trades have been profitable right from the start or shortly after an MAE.

You would now need to know the MAE price, which 70-80% of your winning trades could not cross. You can now use it as a stop loss to modify your trading system. For example, in a stop and reverse system, you can change your stop-loss price and enter a new trade-in reverse direction with the aim of 80% winning trade.

This approach also allows you to put a statistically-backed stop loss while ensuring that there is only a 20% chance of turning around to become a winning trade. You could also apply this using an MAE stop loss at 75%, 85%, 90%. This means at a price beyond 75% stop-loss, you will only have a 25% chance of being a winner and 5% and 10% for the 85% and 90% stop loss, respectively.

You will use your original system’s entry and exit to verify your results, determine if your MAE stop loss needs to be adjusted, and determine if the above methodology is valid.

Maximum Adverse Excursion vs. Maximum Favorable Excursion

Maximum Adverse Excursion (MAE) is the opposite of Maximum Favorable Excursion (MFE).

  Maximum Adverse Excursion Maximum Favorable Excursion
Meaning The MAE measures the amount of any potential loss before the traders implement their trading decisions. The MFE measures the maximum profit that could have been potentially extracted from a particular trade.
Objective MAE helps to avoid disappointing outcomes in the future. In addition, the MAE is used by some traders to determine where to place a stop-loss order for the system that they are trading. Traders use MFE to increase the possibilities of a profitable outcome by increasing their position on the trade relative to the risk.
Graphical representation The MAE graph is depicted by plotting a scatter plot diagram showing each trade’s final profit or loss against its maximum drawdown or the unrealized loss. The MFE graph is depicted by plotting a scatter plot diagram showing each trade’s final profit or loss against its maximum runup or the unrealized gain.

The Bottom Line

This methodology has the benefit of giving you a statistically sound place to put your stop loss because your price might have a high propensity of being a losing trade. MAE will help you to lower risk by preventing lessening losses.

If you don’t know your MAE, you risk placing your stop-loss too close or too far away. If it is too tight, you can exit a trade that could have been a potential winner. On the other hand, a stop-loss is too far away, and you end up losing more money than the trade warranted.

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Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.