Maximum Adverse Excursion
Posted by Mark on October 24, 2012 at 06:53 | Last modified: October 9, 2012 11:13I’ve reached the point with the SPY VIX trading system where I need to analyze maximum adverse excursion (MAE).
MAE is a technique published by John Sweeney in 1997 (John Wiley & Sons, Inc.) that measures the farthest a trade ever goes against you. For long (short) trades, this is calculated with the difference between entry price and the lowest low (highest high) price ever seen during the life of the trade.
MAE is very important from a risk management perspective to help determine potential benefit of a protective stop. A scatter plot of maximum drawdown (MDD) for each backtested trade by final trade profit/loss should be studied. If there is an MDD level beyond which few trades ever end up profitable then it may be useful to keep a protective stop at that level. This may lessen some extreme losers while preserving most of the winners.
The difference between MAE and MDD is that MAE pertains to each individual trade whereas MDD may pertain to an individual trade or a series of trades made by a system.
From a risk management perspective, MAE and MDD both address trader tolerance. Both measure “the farthest X ever goes against you.” Consider the broad stock market as an example. Over the last several decades, the broad market has returned roughly 6% per year. Every now and then, the market crashes and loses 40-60% (or more!) of its value. The MDD is essential to understand because that moment of worst loss is when I will be a nervous wreck, unable to sleep at night, or contemplating a jump out of the nearest 10-story window. If I can’t tolerate the MDD (or MAE) then at best, I won’t be able to reap the benefits of a profitable trade[ing system]. At worst, I may end up suffering catastrophic loss.
In my next post, I will begin to analyze MAE for the SPY VIX trading system.
Comments (3)
[…] were down 80% then would you still be in the market? In 2012 I described this scenario in terms of maximum adverse excursion. Diversification helps to lower risk and while that may lower returns as well, if it can keep me in […]
[…] couple other observations further dim the light on hope. First, the losses are not maximum adverse excursion (MAE): the practical statistic that really matters. Second, it’s important to note this was an […]
[…] is the largest end-of-day drawdown faced during the lifetime of a trade. I blogged on MAE here. MAE may be used to demonstrate the maximum risk ever faced in a single trade. It’s also […]