I have been discovering many ways how to measure potential of trading strategies for last few years and I would like to say there is no a best way. During my discovering I found few methods which are able to quantify potential of trading strategy and I would like to introduce one of them. MAE & MFE is probably one of the simplest methods how to measure potential of trading system. I found this method as a first method and I like this most. MAE & MFE is analysis mostly used by directional algorithmic traders. Beauty of this method is in simplicity.

Maximum Favorable Excursion (MFE)– is a maximal unrealized profit during the period.
Maximum Adverse Excursion (MAE)– is a maximal unrealized loss during the period.

You can find lot of definition of MAE & MFE on the internet. Some of them use term during the open trade. This specification can be right but during the trade means that you already have an and you want to close trade on SL or PT. By hitting one of these closing orders you can get stats but those stats are automatically corrupted and you will never get a potential of the strategy in time scale out of it. If you want to get real and pure stats out of the testing, you need to use time scale analysis.

Timescale analysis

This is an example of one simple entry in time scale analysis. As you can see on the picture above there is a MAE & MFE limit in daily time scale. This is the way how to use quantification of one single signal in trading strategy. Now you have to apply this procedure for each entry generated by the trading strategy.

As you can see in picture below this is really not an easy way how to test a strategy. Method is a simple but is very difficult to make tests with huge sets of data and thousands of entries. You can use open office or excel for few signals as an example but this playground is mostly for algorithmic traders who can run these test in scripts.

Example of MAE & MFE analysis

Now we can specify what you can get out of these tests and what most important is. Take this picture as a demonstration of theoretical model

What you can see on the picture above is result of MAE & MFE analysis in 3 charts. First chart is sum of all bullish signals in trading strategy in 45 days period. Second chart is a sum of all bearish signals in trading strategy in 45 days period and third part is sum of all signals in trading strategy together.

New let’s see charts from a real trading signals

You can see exactly the same stats as previous example just with real trading signals. Now we can try to compare these two examples. Both examples are measured in same time period.

You can see most important thing in these tables in bottom of each table. There is a one row called e ratio and I would like to explain what e ratio is about.

e – ratio

e - ratio is a coefficient which is able to quantify potential of the trading strategy. e - ratio is quantification of sum positive trades (positive potential of the trades in time scale) divided by sum of negative trades (negative potential of the trade in time scale). As you know, one of the most profitable ways in the trading is picking a signals with good risk - reward ratio. MAE and MFE analysis measures the potential not only for one trade but for whole system. This is biggest advantage of this analysis and e – ratio is interpretation of this potential. See charts below.

MFE / MAE = e-ratio (higher number is better,everything over 1 is good result)

As you can see e-ratio in theoretical model is over 1 all the time. Real strategy result shows e-ratio over 1 only in 10-45 days interval, but then is higher than theoretical model. Is it better result or not? No, it is not.

This chart above is saying something important very strictly. Even if potential in real trading strategy in long term is very positive, system has no a good entry points. These stats can be corrupted by the random walk factors (huge bullish or bearish trend, disproportion in Long side and Short side trades and other factors). MAE & MFE analysis is study of potential of strategy in first place and validation of entry points in second. Exits are very important in trading but testing is not about exits in this case. Money management is most important thing in trading but it is completely different step from developing strategy procedure. We cannot mix all this steps together.

MAE & MFE Charts for different trading styles.

I would like to say one important note at the end. MAE & MFE analysis is powerful tool for potential measurement, validation of entries and is also helpful as a first step for simple money management setup. But is not a tool which can solve all problems. You need to be aware this analysis is only mathematical concept and is not very smart to using this without basic logic. You need to make a huge statistical sample. Another thing is that for different trading styles you are looking for a different entry quality and potential. For scalpers is most important thing first few minutes, for swing traders solid distribution in first hours and for investing or long term style traders is most important thing on the right side of the table. There is only one rule you need to follow. You need to have an e-ratio always more than 1. E ratio over 1.5 means that you have a powerful and robust trading strategy.