VI. How to find a good entry point? MFE/MAE analysis. PART 1
VI. How to find a good entry point? MFE/MAE analysis. PART 1
Let's move on to the tactical vision and think about how to evaluate the quality of one or another entry point algorithm for a given trading instrument.
One such approach is MFE/MAE analysis. What is it? Consider the picture below:
Suppose we entered a long position at some point on the price chart (black arrow in the figure). We can take any time window and check for what maximum distance the price shifted in the direction of profit (green zone) and in the direction of loss (red zone) within this window after we entered the position. The value of the largest price offset in the direction of profit is called “Maximum Favourable Excursion (MFE)”. The value of the largest price offset in the direction of loss is called “Maximum Adverse Excursion (MAE)”. In the figure, the MFE value is equal to 3.93, and the MAE value is equal to 11.33. If we divide the MFE value by MAE, then we get some MFE/MAE coefficient (in our example, MFE/MAE = 0.35).
Why do we need it? Using these values (MFE and MAE), we can estimate the quality of the strategy entry algorithm. If we calculate the MFE/MAE coefficients for all trades and then take the average, then we can quantify how much advantage our entry algorithm has.
· If the ratio MFE / MAE = 1, then the entry point does not give any advantage.
· If the ratio MFE/MAE <1, then the entry point has a negative advantage — you can try to change the direction of entry into the deal (instead of a long position, use a short one and vice versa).
· If the ratio MFE/MAE > 1, then the entry point has an advantage and gives a better chance to enter a trade with less risk.
The higher the value of the MFE/MAE coefficient of 1, the better for our strategy.
It must be said that the entry point algorithm itself can be quite complicated and contain many filters. For example, while engaging in strategy automation for one public trader who trades CME futures, we counted about 7 filters for his entry algorithm. These filters need to be digitised one way or another.
Let’s consider usage of MFE/MAE coefficients by example. We will test different entry algorithms for the SPY instrument. (ETF trading stocks from the S&P 500 index). We took data for the last 25 years — since 1993. We will test entry points for the W1 timeframe.
It is necessary to decide for what period to test the data of the trading instrument and what timeframe to use to analyse the entry algorithm. For the purity of the experiment, the testing period should contain different market conditions: low- / highly- volatile, trend / non-trend.
For example, a few simple entry methods were used:
- HHV/LLV (Donchian channel) breakthrough for the last 20 candles.
- Two consecutively growing/falling candles
- Three consecutively growing/falling candles
- Candle crossed EMA (20)
- Random entry
Before testing the entry points, it is necessary to determine the size of the time window for the computation of the MFE/MAE coefficients. The size of this window should be taken commensurate with the position holding time, which the trading strategy implies. In this test, we used 96 weeks (about 2 years) as the maximum time window period.
Since the size of the time window when computing the MFE/MAE is a parameter, it would be nice to see the dynamics of this coefficient, depending on the selected time window parameter.
We calculated the MFE/MAE coefficients for the five entry points indicated and sorted the entry points by decreasing the MFE/MAE coefficient for them:
The highest MFE/MAE coefficient is obtained for the “HHV/LLV breakthrough (20)” entry point. So this coefficient looks in dynamics, depending on the selected time window from 1 to 96 weeks:
In fact, the first 5 weeks the curve value is below one. This suggests that in the short term, if you hold a position for 1–5 weeks, the entry point when breaking the Donchian channel does not give an advantage (but a slight advantage will arise if we open a position in the opposite direction of the break). Starting from the 6th week, the value of the curve becomes more than one. The advantage reaches its peak somewhere on the 60th week (about 1 year) and is approximately equal to 1.9. It means that if, after Donchin’s channel breakthrough, we will be holding SPY for about 1 year, then we will have 2 times more chances to win than to lose. Holding a position longer than 1 year does not make sense, because during this period, the curve reached its peak and no further growth of the advantage can occur.
For the “Three consecutively growing/falling candles” entry point the MFE/MAE coefficients curve turned out to be the following:
This entry point is less beneficial than the “HHV/LLV breakthrough (20). The maximum value of the MFE/MAE curve is 1.6. The MFE/MAE coefficient becomes greater than one only from the 18th week of holding the position.
For the “Candle crossed EMA (20)” entry point the MFE/MAE coefficients curve turned out to be the following:
This curve is stable, growing over the period from 1 to 50 weeks. Then the growth rate of the curve decreases. The MFE/MAE coefficient becomes greater than one from the 8th week of holding the position.
For the “Two consecutively growing/falling candles” entry point the MFE/MAE coefficients curve turned out to be the following:
This curve is stable, growing over the period from 1 to 50 weeks. Then the growth rate of the curve decreases. The MFE/MAE coefficient becomes greater than one from the 8th week of holding the position.
For the “Two consecutively growing/falling candles” entry point the MFE/MAE coefficients curve turned out to be the following:
Note that the curve in the time interval from 1 to 96 weeks is in the neighbourhood of one. This suggests that a random entry point does not give any advantage. When randomly entering the price can go in the direction of profit and loss at the same distance.
There is a widespread opinion among traders that the entry point is not important, since it does not determine the profit in the deal. That exit point determines the profit in the deal, and the entry point can be selected randomly. Yes, it’s true (exit point determines the profit in the deal). But it is the qualitative entry point that allows you to enter a position with minimal risk and maximise the chances that the price will move in the right direction. Traders should continuously develop this skill throughout their career.
And finally: you can take your trading journal and carry out such an MFE/MAE analysis and assess how well you manage to determine entry points and also understand whether you are entering the deal randomly.
CONCLUSION:
1. MFE — Maximum Favourable Excursion. It is the value of the largest price offset in the direction of profit from the entry point. MAE — Maximum Adverse Excursion. It is the value of the largest price offset in the direction of loss from the entry point.
2. The ratio (coefficient) of MFE/MAE allows us to quantify how qualitative our entry point is. The higher the MFE / MAE value of 1, the more likely it is to enter a trade with less risk.
3. For greater clarity, it is better to consider the MFE/MAE coefficient in dynamics — depending on the selected time window parameter.