## The concept of Maximum Adverse Excursion MAE

Let's take a look at the MAE graphic of our trading system (Figure 3.11). This graph shows all 902 trades that are produced within the tested period. For each trade you can see the amount of drawdown that occurred in relation to the realised profit or loss. The winning trades are shown as green up arrows and the losing trades are represented as red down arrows. On the vertical y-axis of the MAE diagram you see the final profit whereas the horizontal x-axis shows the intraday drawdown of each trade.

Since we are using this graphic to determine where to place our stops we have put all the winning and losing trades on the same cluster graph. This means that although trades A and B in Figure 3.11 appear to be similar they are in reality quite different. Trade A had a drawdown of \$2400 and closed at a final loss of \$1000. Trade B, on the other hand, suffered an even bigger drawdown of \$2500 but recovered and managed to end with a gain of \$1000. Whether the dollar amount indicated along the y-axis is a profit or loss is determined by the colour and the direction of the small triangles. Keeping the trades clustered on the same graph makes it easier to figure out how much unrealised loss must be incurred by a trade before it typically does not recover. In this way the MAE graphic tells you when to cut your loss because the risks associated with the trade are no longer justified. This gives you a valuable indication of where to place your protective stop.

Figure 3.11: The MAE graph of LUXOR system. Green: winning trades, red: losing trades. System tested on British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. Input parameters SLOW=44, FAST=1. Without exits, always in the market, including \$30 S+C per RT. Diagram created with TradeStation 8.

Figure 3.11: The MAE graph of LUXOR system. Green: winning trades, red: losing trades. System tested on British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. Input parameters SLOW=44, FAST=1. Without exits, always in the market, including \$30 S+C per RT. Diagram created with TradeStation 8.

In order to decide where to put this stop we show the same MAE graph in percentage terms (Figure 3.12A). We switch to percentage terms since the percentage display gives a better adaptation to changing market conditions than fixed dollar values. Especially on markets with big point value changes the advantages of the percentage based calculation become obvious. In such conditions it is better to work with exits that are adapting to the current market value instead of staying fixed and inflexible.

Figure 3.12A: MAE graph in percentage terms. Green up arrows = winning trades, red down arrows = losing trades. Trend-following system British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. Input parameters SLOW=44, FAST=1. Without exits, always in the market, including \$30 S+C per RT. Diagram created with TradeStation 8.

Figure 3.12A: MAE graph in percentage terms. Green up arrows = winning trades, red down arrows = losing trades. Trend-following system British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. Input parameters SLOW=44, FAST=1. Without exits, always in the market, including \$30 S+C per RT. Diagram created with TradeStation 8.

Figure 3.12B: Maximum Adverse Excursion graph in percentage terms after inserting a 0.3% stop loss into the system. LUXOR system tested on British pound/US dollar (FOREX), 30 minute bars, 21/10/2002-4/7/2008, with entry time window 9.30am-1.30pm GMT. Input parameters SLOW=44, FAST=1. Diagram created with TradeStation 8.

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Let us briefly explain some trades from the MAE diagram in order to become more familiar with it. First you see that the relative positions of trade A and B explained above have changed. Trade A is now on a higher position in y-direction since the two trades took place in different times when the market was trading at a different level. Because the calculation is now based on percentage of the underlying market, the same dollar values usually mean different percentage values.

When watching all these 902 trades in the MAE diagram you can see some characteristics of the trading system. The first point is that on the left side of the diagram you find more winning than losing trades. This is clear since winning trades usually don't suffer such big drawdowns as losing trades. The "best" trades for you are obviously the ones which behave like trade C - trades that are profitable from the beginning without suffering any negative open equity in their lifetime and are placed on the very left side close to the y-axis of the diagram (profit/loss axis).

Another interesting area of trades is what we call the "loss diagonal". On this characteristic line you can find a lot of losing trades. Like trade D all these trades ended with a loss which represents their biggest drawdowns. On the other hand, trades like E also exist. This trade suffered a big drawdown of over 3.5% from the entry-point but recovered from this position to a final loss of only about 0.5%.

Now we want to place a protective stop loss at a certain distance (percentage of market value) away from the entry point in order to limit the risk of the trade. How does the MAE diagram help you to determine a good distance for this added stop?

Let us look how the MAE diagram helps to understand what an inserted stop loss does in your trading system.

The stop loss in the MAE diagram can be drawn as a vertical line. Such a stop loss theoretically cuts all trades that suffer a bigger loss from their entry than this set stop loss (Figure 3.12B). In the MAE diagram this means that the stop loss prohibits all the trades on the right of the 0.3% line and moves them to this line. This sounds good for all the losses (red points) that are made smaller by this stop. But think about all the winning trades. They are turned into a red spot, a loss of 0.3%, as soon as they reach the stop loss and never get the chance to become a winning trade.

We try to place a stop in an area that captures the majority of winning trades while simultaneously limiting the strategy's exposure to profit erosion. Obviously it is good to set a stop loss so as to cut as many trades which end on the loss diagonal as possible without affecting trades that end as winners, or at least those trades that recover from their lowest points.

So the question is what happens if you make the stop loss smaller than 0.6%, going to 0.4%, 0.3% or even 0.1%? Obviously you will then cut more and more trades that are ending on the loss diagonal and for which the stop loss does a good job in cutting them early enough. But the more you move your stop loss to the left side, the more trades you also cut which recovered from their biggest drawdowns or which even ended as winning trades.

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### Responses

• Prima
How to use maximum adverse excursion?
2 years ago