Maximum Favorable Excursion (MFE) is the highest potential profit a trade earns before it is closed. Traders can use MFE to evaluate the trading system’s performance and maximize their profit potential by setting optimal take profit targets. The MFE is best suited for mechanical trading systems.
Maximum Favorable Excursion (MFE) is the highest potential profit a trade earns before it is closed. Traders can use MFE to evaluate the trading system’s performance and maximize their profit potential by setting optimal take profit targets. The MFE is best suited for mechanical trading systems.
How to Use MFE
When the MFE is high on losing trades, it implies that you gave up potential profit or took a more significant 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, it would be best to strike a balance while adjusting the placement of orders. If the profit-taking approach is too conservative, it could lower expectancy. Hence, the aim is not to reduce your overall expectancy while giving back the profits.
The below graph from The Maximum Favorable Excursion Strategy reprinted from Technical Analysis of Stocks & Commodities magazine 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 run-up or unrealized gain that the trade achieves during the course.
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 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 run-up 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 act 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 must 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 crucial stage 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 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. The maximum favorable excursion is a dynamic analytic beneficial to both mechanical and discretionary traders.
