The recent swings in Nifty futures price bring to the fore two metrics relating to your trading account: maximum adverse excursion (MAE) and maximum favourable excursion (MFE). MAE refers to the maximum unrealised loss you had on your winning trade before you took profits on the position. MFE is the opposite of MAE. It refers to the maximum unrealised gains your position carried before you closed it for lower gains. This week, we discuss how MAE and MFE relate to your futures trading.  

Maximum excursions

Suppose you initiated a long position on the near-month Nifty futures at 24,230. Assume you take profits at 24,660. During the time your position was open, suppose the futures price went to a low of 23,905. The MAE would be 325 points (24,230 less 23,905). Given the permitted lot size of 25, your winning trade at one point had an unrealised loss of 8,125; your stop-loss would have been below MAE. Now, suppose the Nifty futures later rose to 24,730 but you eventually took profits at 24,660. The MFE would be 500 points (24,730 less 24,230). Periodically reviewing your MAE and MFE can improve your trading performance. How?

Suppose you actively trade the near-month Nifty futures contract. You can use the previous MAE on the security as your stop-loss. Note that MAE for short position will be the difference between the entry price and the highest price the position recorded before the winning short trade was closed. For another, you can use MAE in conjunction with MFE. While MAE works to your benefit as it is unrealised loss, MFE shows the maximum gains you could have made. MFE is your upside potential and MAE your downside risk. If your MAE is greater than MFE, you can set a tighter stop-loss. You must, of course, be mindful that a tight stop-loss could stop you out of the trade. Alternatively, you can adjust your price target upward to improve your trading performance. Note that MFE indicates whether your profit-taking rules are optimal. The lower your selling price compared to the MFE, the less optimal your profit-taking rules. 

Optional Reading

MAE and MFE are important when the market is mean-reverting or trading in a range. That is when price reversal strategies work better than trend-following strategies. Trades with high MFE may need better profit-taking rules, and trades with low MAE can be carried with tighter stop-loss. Importantly, you can use MAE as a reference level to back-test and validate your stop-loss rules. For instance, would a stop-loss based on Wilder’s Parabolic SAR have worked better to adjust for market volatility? How about average true range (ATR)? You should continually review your trading system’s MAE and MFE to modify your trading rules. The system can be applied on the underlying price to manage your option trades, though it may not be as optimal because of an option’s gamma and theta. 

Upside & downside
MFE is your upside potential and MAE your downside risk. If your MAE is greater than MFE, you can set a tighter stop-loss

The author offers training programmes for individuals to manage their personal investments

Published on December 6, 2024