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Maximum Favorable Excursion (MFE)

Maximum Favorable Excursion (MFE) is the highest potential profit that a trade earns before it is closed. Traders can use MFE to evaluate the performance of the trading system and maximize their profit potential by setting optimal take profit targets.

Key Takeaways

  • MFE helps traders understand the differentiating factor of the average trades from those with more significant profit potential.
  • MFE is the highest potential profit that a trader earns before the completion of the trade.
  • This strategy helps traders enhance their profit potential relative to the risk by setting optimal take profit levels.
  • A trader should re-assess the system’s performance after applying the MFE strategy to ensure that the risk-reward characteristics are intact.
  • The MFE graph is depicted by plotting a scatter plot diagram showing each trade’s final profit or loss against its maximum unrealized profit.

Table of Contents

What is Maximum Favorable Excursion?

Maximum Favorable Excursion (MFE) is a concept propounded by John Sweeney to evaluate the distinct features of profitable trades. It is an analytical tool that empowers traders to understand what differentiates the average trades from those offering more significant profit potential. Technically, MFE is the highest profit that a trader earns before the completion of the trade. We can measure the MFE of all the trades by reviewing the performance of a trading system.

For instance, you have a closed trade that lost 30 pips, but when the trade was open, it did touch a profit of 150 pips at some point. So this highest potential profit was the Maximum Favorable Excursion for that particular trade. If the MFE is significantly higher than the resultant profit of the trade, it implies that you are leaving a lot of profit on the table. You need to set better profit targets to lock the money you could have earned.

We can apply MFE on losing trades too. These are mostly a handful of trades wherein you could have earned a decent profit, but ended up incurring losses for some reason.

In a nutshell, your average MFE could give you indications on how to not leave too much profit on the table.

Why Is MFE Important?

MFE analysis helps traders classify a well-performing trade and use the MFE risk management strategy to increase the profitability of the opportunities identified in due course. Using this strategy, traders can enhance their profit potential corresponding to the risk by optimizing the profit target.

The MFE strategy applies all trading systems, whether discretionary, systematic or algorithmic, long, short, or intraday.

The returns generated by the system display exploitable characteristics to make the most of this risk management strategy. Every trading strategy is different; hence traders need to conduct a thorough performance evaluation to understand the suitability of the MFE strategy.

The main aim of the MFE strategy is to add to positions offering superlative profit potential during the trade and set optimal profit zones. Considering this, firstly, you need to determine whether the trading system exhibits actionable MFE characteristics. Secondly, you need to select the point at which you intend to add to the positions. Finally, you need to re-assess the system’s performance post applying the strategy. The risk-reward characteristics must stay the same even after using the MFE.

MFE is extremely useful because it can help you to achieve the following goals:

  • Allows your trades to have better risk/reward characteristics.
  • Helps you from locking in profits too early or too late.
  • Enables uou to set optimal profit targets for your trades.

A video by UKspreadbetting explains the working behind Maximum Favorable Excursion in a lucid way.

How to Use MFE

When the MFE is high on losing trades, it implies that you gave up potential profit or took a larger loss than necessary before it ran into the stop loss. This inspires a trader to alter her approach by using a slightly more conservative profit target.

However, you need to strike a balance while adjusting the placement of orders. If the profit-taking approach is too conservative, it could lead to lower expectancy. Hence, the aim is not to reduce your overall expectancy while giving back the profits.

This graph from the maximum favorable excursion strategy displays every trade’s unrealized profit in a scatter graph format. It is used to determine opportunities to add to positions.

The vertical axis represents the closed profit or loss for each trade. The horizontal axis represents the amount of runup or unrealized gain that the trade achieves during the course.

Maximum Favorable Excursion Example

For example, trade A was a winning trade with a run-up of more than 5% and ended with a profit of 5%. On the other hand, Trade B was a losing trade with a run-up of about 2%. However, eventually, the position reversed to end with a loss of over 3%. Thus, the MFE graphic is a powerful tool for evaluating the efficiency of each trading strategy.

Maximum Adverse Excursion vs. Maximum Favorable Excursion

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

  Maximum Favorable Excursion Maximum Adverse Excursion
Meaning The MFE measures the maximum potential profit of a trade. The MAE measures the amount of potential loss of a trade
Objective Traders use MFE to increase the possibilities of a profitable outcome by increasing their position on the trade relative to the risk. MAE helps to avoid disappointing outcomes in the future. In addition, the MAE is used to determine where to place a stop-loss order for the system that they are trading.
Graphical representation 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 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 Bottom Line

The path to profit matters more than the win ratio alone. If the course of attaining profit is too challenging, the trading strategy may not be sustainable. This is why statistics like the MAE acts as a criterion to assess the quality of the entry and exit signals generated by the trading system.

They also help segregate the high performances during a trade from the average, thus identifying opportunities to increase profitability. This can be achieved by increasing the profit potential relative to risk by adjusting the target profit zone.

If you want to use the MFE analysis, you need to follow a thorough process. In the first stage, the maximum favorable excursion graphic evaluates the properties of the system to check for any exploitable tendencies. This is a crucial stage that can help us remove inefficient trading systems that offer the minimal potential to exploit the link between the sudden price spurt and realized profit.

The second stage involves finding a suitable MFE support level crucial while adding on to the positions. Finally, testing the permutation of various values is equally important. As a trader, you need to test specific values to determine the optimal level of MFE. In a nutshell, the maximum favorable excursion is a dynamic analytic beneficial to both mechanical and discretionary traders.

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Leo Smigel

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