Select Page

# Using Maximum Adverse Excursion for Stop Loss Placement

Jul 26, 2021

A catastrophic stop loss is a vital risk management tool for many traders. Here I’ll show you how to optimize your stop loss distance using maximum adverse excursion.

In the diverse world of strategy development, there are often multiple approaches to the same problem.

Traditional parameter optimization is often used to determine your strategy’s stop loss placement.

Here I’ll demonstrate a more visual method using the concept of maximum adverse excursion, and compare the results from both methods.

## What is Maximum Adverse Excursion?

Maximum adverse excursion (MAE) is the largest floating loss during a trade. It measures the furthest that prices moved against you.

Let’s say you enter a long trade at \$100, and the market progresses as shown:

Your MAE in this case would be the \$20, the difference between the entry price and the lowest market price during the trade.

If you never experience a floating loss during a trade, your MAE will be zero.

Here’s a case study:

Suppose you have a reversal trend following strategy for the GBPJPY. Since the strategy is always in the market, you decide to add a catastrophic stop loss to limit risk.

To determine stop loss placement using MAE, you first need to plot your individual trade distribution from the backtest.

MT4’s Strategy Tester doesn’t calculate MAE; you can use StrategyQuant to run the backtests instead. For each trade, there are two metrics you’ll need:

1. Closed profit/loss
2. MAE

I like to use pips instead of \$ values, because currency pip values fluctuate over time.

With these two values, you can plot the following MAE chart using Excel:

For every backtest trade, the chart displays the closed profit/loss in relation to the MAE during the trade.

Notice that the vast majority of wining trades have low MAE values. Winning trades are usually profitable quickly, experiencing only small floating losses.

Also notice the ‘Loss Diagonal’ consisting of losing trades. These trades were exited close to their lowest equity point.

Let’s look at trades A and B. Although they’re located in the same area, they progressed very differently.

Trade A had a MAE of 580 pips, and was eventually closed at a 580-pip loss.

Trade B had a MAE of 600 pips, but managed to recover, eventually closing with a 500-pip win.

Let’s now use this chart for stop loss placement.

## Using Maximum Adverse Excursion for Stop Loss Placement

By analyzing the distribution of MAE in relation to the eventual profit/loss, you can estimate how much floating loss a trade can incur before it is unlikely to recover.

You can place your catastrophic stop loss at this MAE level, because the risks associated with the trade are no longer justified.

Adding a stop creates a vertical boundary at a particular MAE value. Once this value is hit, the trade is immediately closed at a loss. Below you can see the same MAE chart, but with a hypothetical 200-pip stop loss.

All trades to the right of this 200-pip stop loss will be shifted onto this line. This seems great because you’ll be removing the big losses, but you’ll also sacrifice a portion of your winning trades.

These winning trades experienced a MAE of 200 pips or more, but managed to recover to close in profit.

An optimal stop loss thus removes the big losses, without choking off too many trades that eventually became profitable.

From the MAE chart, you can estimate that the ideal stop loss would be in the 50-150 pip range.

As a first pass, I recommend placing your stop such that you retain 75-85% of your winning trades. I’ll demonstrate this using an 85% cut-off.

Using the backtest statistics, I’ll place the stop such that any trade that hits the stop level has only a 15% chance of recovery.

The reversal strategy above contains 442 winning trades. This means I need a stop level that retains 376 (85% of 442) winning trades. This corresponds to about a 100-pip stop.

Here’s how the MAE chart looks with a 100-pip stop.

There is a concentration of losses at the 100-pip MAE value where the trades are taken out by the stop loss.

Note that many trades have a MAE of 101 pips because my backtest models a 1-pip slippage. In actual trading, during times of extreme volatility, stop loss slippage can increase drastically.

## Comparison with Stop Loss Optimization

How does the above MAE method compare with traditional parameter optimization?

In parameter optimization, a parameter of interest is varied across a wide range, with the optimal value producing the best strategy performance. This versatile method can be used to select anything from trading entries to profit targets and trailing stops.

Here I’ll perform stop loss optimization using StrategyQuant’s Optimizer.

The stop loss was varied from 10 to 250 pips, in steps of 1 pip.

The return/drawdown ratio is negative for very small stop values; excessively tight stops are often a recipe for disaster for trend following systems. You need to be willing to take bigger risks to overcome transaction costs in the form of spread, slippage and commissions.

There is a high plateau in the 90 to 120-pip stop loss region. I would pick the middle of this plateau (105 pips), which is pretty close to the value obtained from the MAE chart.

## Wrapping Up

Stop losses are great at limiting your capital downside and market exposure; many traders thus consider them to be mandatory.

Using MAE to determine stop loss placement is a viable alternative to traditional parameter optimization. Obtaining similar results from both methods gives you confidence that your strategy is conceptually sound.

Complementary to MAE is maximum favourable excursion (MFE). MFE is the largest floating profit during a trade, and can be used to study whether profit targets would be beneficial for your strategy.

If you want to experiment with StrategyQuant’s cool features, don’t forget to check out the 14-day free trial!

## Popular Posts

The page you requested could not be found. Try refining your search, or use the navigation above to locate the post.

#### Make your money work for you!

Get promotions, trading ideas and strategy development tips delivered to your inbox!

1. Do you have the code for excel for creating the MAE/MFE chart?

• no it was done manually. Just a quick scatter plot

2. Can you further discuss what is “loss diagonal”? It is new to me and I don’t know why it is formed. Thank you! <3

3. I believe there shall be a Quant method to decide the optimal stop loss level for MAE instead of visually assign a value defined by 75%-85% winning trade. What do yo think Wayne?

4. great job!

## Ichimoku Trend Following Strategy

Like candlesticks, the Ichimoku indicator is a fine Japanese creation. Here I’ll explain how the Ichimoku is plotted, and use it to build a trend following strategy for the USDJPY.

## Forex Trading With Volume – Does It Work?

Volume is seldom discussed in forex trading. But as a stock trader would tell you, volume provides insights into the underlying market sentiment. Here I’ll demonstrate the use of two simple volume filters to improve entry reliability.

## What Is the Kaufman Adaptive Moving Average?

The Kaufman Adaptive Moving Average is a unique indicator that automatically adapts to the market’s noise. Here I explain its inner workings and show you how to build a trend following strategy around it.

## Awesome Oscillator Forex Trend Strategy

The Awesome Oscillator is one of Bill Williams’ fine creations. It is a simple yet effective momentum indicator that can be a valuable addition to your strategy. Here we’ll use it together with a moving average to fine-tune our trend following entries.

## Dual CCI Indicator Forex Trend Strategy

The Commodity Channel Index (CCI) is an underrated momentum indicator that is often overshadowed by the RSI and MACD. I’ll show you how to build a simple trend following strategy using a pair of CCI indicators!

## What is Fixed Ratio Money Management?

Have you heard of fixed ratio money management? How does it compare to the popular fixed fractional approach? Here I’ll explain how fixed ratio works, and see how it stacks up against fixed fractional money management.

## What Is the Kaufman Efficiency Ratio?

Avoiding false breakouts is a common goal among trend traders. The Kaufman Efficiency Ratio provides a simple method of quantifying a market’s noise, helping traders focus on the smoothest trends. Let’s add the efficiency ratio to a simple trend following strategy and see whether its performance improves.

## What Is the QQE Indicator?

The QQE is a mysterious indicator that sometimes pops up in trading forums. Does it deserve a place alongside the more traditional momentum indicators like the RSI and CCI? Let’s add it to a trend following strategy to find out!

## Do Bollinger Bands + Candlestick Patterns Work?

Bollinger Bands are great at detecting overbought and oversold conditions. Let’s use them to develop a countertrend strategy, and then refine our entries using limit entries and candlestick patterns.

## How Good Are The Bollinger Bands’ Trailing Stops?

Trailing stop losses are a popular feature in many trend following systems. Bollinger Bands, the ever-popular technical indicator among retail traders, actually contain two inbuilt trailing stops. Are these any good? Let’s find out!

## Bollinger Bands vs. Keltner Channels

Bollinger Bands are ubiquitous in the trading world, but there’s less discussion about their lesser-known cousin, the Keltner Channels. Do these perform as well as the Bollinger Bands? Let’s compare them over a broad range of input parameters.

## Strategy Development

The page you requested could not be found. Try refining your search, or use the navigation above to locate the post.

The page you requested could not be found. Try refining your search, or use the navigation above to locate the post.