Maximum Adverse Excursion (MAE Trading) and Maximum Favorable Excursion (MFE)

Maximum Adverse Excursion (MAE Trading) and Maximum Favorable Excursion (MFE)

When trading, it’s normal for the price to move a lot, often going against you before turning to move in your favor again. You can minimize the risk of loss in your trade by observing the price action and being aware of the Maximum Adverse Excursion (MAE) and Maximum Favorable Excursion (MFE) on your trades can help improve your trade entry point and stop-loss.

What is Maximum Adverse Excursion(MAE)

Maximum Adverse Excursion (MAE) is a metric used to measure the largest loss experienced during a single trade before it closes. It is an unrealised loss, probably best charaterized by that sinking feeling you get just before you are tempted to panic sell. It is the highest price your asset reached during a short trade and the lowest it reached during a long trade. 

MAE Trading- MAE (Maximum Adverse Excursion)

Let's look at an example, say you have a long trade entry at $25 but the asset’s price eventually dropped to $15 before suddenly rising to $50 while the trade is still open. The maximum adverse excursion for this trade would be $10, which is $25 minus $15 which was the lowest price it reached.

But, the MAE is a statistical metric so finding the right value involves reviewing a series of trades. For example, if you ended up recording 5 adverse movements in a series of 5 trades: 5, 10, 12, 14, and 7, your MAE would be 14. 

Keep in mind that if a trade does not move into the negative position at all, then your maximum adverse excursion would be zero. For example, if a long trade’s price was always more than the entry price or the price of a short trade remains lower than the price for entry during the entirety of the trade, then your maximum adverse excursion would be at zero. 

An MAE can also be expressed using a percentage. Say you have a long trade entry at $100 with the lowest asset price at $94 before the trade closes. This gives you an MAE value of $6.

If you have your stop-loss at $90, you can express your MAE value as 60%, $6 is 60% of the maximum loss you will accept which is your stop loss. 

Having an extremely low MAE value is helpful for enhancing the trader’s expectancy and the size of their profits by utilizing a tighter stop. However, you must be careful when adjusting your stop size as a closer stop might end up resulting in a higher loss rate instead.

Understanding MAE (Maximum Adverse Excursion)

For a better understanding of MAE, you can try applying the OHLC (Open, High, Low and Close bar) logic to your long trades.

Your trade entry is the Open price and your MAE value is the difference between your Open price and the Low. It shows you how the trade price went against you before eventually turning in your favor again during the duration of the trade. 

Conversely, the ‘High’ represents how high the trade price went in your favor, known as the Maximum Favorable Excursion we talk more about it below. Finally, the ‘Close’ represents your exit/take profit, which hopefully lies somewhere between the prices of your ‘Open’ and ‘High.’ 

You can also apply the same logic to short trades. However, in this case, the value of your Maximum Adverse Excursion is the opposite, that is the difference between the ‘Open’ and ‘High’ prices

Meanwhile, the ‘Low’ represents the farthest distance that the trade has moved in your favor, with ‘Close’ representing your exit/take profits found somewhere between the prices of your ‘Open’ and ‘Low.’

MAE Trading- MAE Graph

MAE (Maximum Adverse Excursion) vs MFE (Maximum Favorable Excursion)

It helps to differentiate between an MAE and an MFE to better grasp the concept of both. An MFE, which stands for Maximum Favorable Excursion, is another statistical metric. 

The main difference between the two is that MFE focuses on another aspect of trading. If the MAE places focus on potential risks and loss, the MFE (Maximum Favorable Excursion) concentrates on profit. It is used to measure the largest potential profit you can make while your trade is still open. 

Knowing how to properly apply the concept of an MFE can help you place your profit target properly in a way that prevents you from taking profits too early. 

Importance of MAE (Maximum Adverse Excursion)

One thing about Maximum Adverse Excursions/MAEs is that they diverge from anything biased and subjective to statistical calculations so that traders are more able to objectively define their loss points.

With the help of an MAE, the amount of any potential loss is highlighted, helping traders properly reconsider any trading decisions they make.

Other than helping you maximize profits and reduce losses; the MAE is also essential in a few other areas such as:

Risk Management

From the perspective of risk management, an MAE can be used to determine any potential benefits you can gain from a protective stop. It can also be used by a mutual fund for evaluating its trading strategy and identifying its exposure risks. 

MAE Trading- Risk Management

Position Sizing

Knowing the value of your MAE, you can increase your position size proportionally and reduce the size of your stop loss all while keeping your risk the same. The following formula shows the general amount of dollars you risk in a single trade:

Amount at Risk = Size of Position x Size of Stop Loss x Position Size Unit Value

Say you have an initial stop loss size of 25 points. When you enter 10 points lower, you can have your stop loss safely at 15 points. Since your stop loss is reduced to 60% of what it was, your position size can be increased by 1.6x. In this case, you’d still be risking about the same amount in a trade even with the significant change in your position size.

Optimal Stop Loss Placement

For every winning trade you have, it’s important to know the MAE value or how far your trade price dropped before eventually turning around in your favor. You can use the MAE value that covers around 70-80% of your winning trades and have it be the stop-loss used to modify your trading system.

The MAE can be used to figure out the optimal stop loss that can minimize the size of your losses and doesn’t stop out immediately. If your trading system is of the stop and reverse type, it’s possible to modify it to reverse the stop loss placement and then create a completely new trade entry in the opposite direction. 

Here is an 8-minute video explaining more about MAE

Final Thoughts

The MAE is definitely an important metric to use in your live trading system. It allows you to analyze the movements of your trade and act accordingly. Having a firm grasp of the concept of an MAE can greatly help in maximizing profits and minimizing losses.

You might be also interested in our guide to out of the money OTM calls and what is the S&P 500 Sharpe Ratio.

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