Stops and Max Adverse Excursion

[Predictor 11]

Stops And Max Adverse Excursion

 

It is often difficult to apply stop losses effectively to mean reversion systems. In order to understand why one needs to understand how the max adverse excursion (MAE) and the average win/loss relate. First, the MAE is the greatest drawdown that a position/trade experienced. MAE is the worst heat a position takes.

 

If one only looks at the distribution of the closed profits/losses then it might appear that a stop could easily be applied to make the system better. For example, imagine that the distribution was similar to the following:

 

% of Losses, Avg Loss

60%, < $250

20%, < $350

10%, < $500

5%, < $600

Rest, < $1000

 

All figures in absolute value terms for ease of reading.

 

Based on the size of the losses, it might first appear that one could set a stop somewhere around $500 on this system. However, if we drill down into the MAE we will often see something that looks like this:

 

AVG Loss, MAX MAE

-$250, < $535

-$350, < $710

-$500, < $1200

-$600, < $1600

Rest, < $2500 (MAX MAE EVER)

 

In other words, if we set a stop on this system of $500 then we increase the average $250 loss to an average $500 loss! Likewise, we increase the average $350 loss to a $500 loss. The only possible result is that the drawdown for this system will increase.

 

I find it highly valuable to study the MAE, MFE (MAX FAVORABLE EXCURSION), MAX LOSS, and AVG WIN/LOSS for a trading system. I did an analysis on a subset of my own trades and found that my average winning trade only experienced about 2 points of heat. In other words, I found that my entries were very precise and didn't take much heat. However, when I attempted to apply a tight stop: my performance would have suffered a considerable hit. After some study, I found that the reason was that a considerable portion of my performance came from exiting losing trades at relatively favorable prices.

 

Even though tight stops will not work: there are methods that can be used to manage the risk in trading such a system. One option is trade the system without a stop loss and use a smaller account. Another method is to set the stop where it decreases performance the least. A third and similar option is to set the stop slightly greater then any historical loss. There are advantages and disadvantage with any of these methods.

 

Curtis

http://themarketpredictor.com