Every CTA Needs an Edge...

Sherwood Tucker, of Tucker Trading & Consulting, breaks down the intricacies of positive and negative price movement in relation to trading entry position and why one of the key aspects money managers look for is if their technique has an ‘edge’ for the time frame they are trading.   

When a Commodity Trading Advisor (CTA) or Money Manager is testing or back-testing their entry signals, one of the most important aspects they look at is if the technique they are using has a distinct edge for the time frame they are trading (short-term, swing, long-term, etc).

Positive price movement is when the market goes in the direction of the trade. In other words, when you buy, it’s good when the market keeps going up and bad when the market moves lower.  When you sell short, it’s good when the market moves down and bad when the market moves against you and goes higher.  Also, you need to consider those cases when you buy and the price initially goes down—which is bad for the trade—and then reverses and goes above your entry price and moves higher.

In trading, a move in the bad direction is referred to as ‘maximum adverse excursion’ and the maximum move in a good direction is referred to as ‘maximum favorable excursion’ (MFE).  You can use these two components to directly measure the edge of an entry signal.

If a certain entry signal generates a move in which the average maximum good movement was higher than the average maximum bad movement, this would show that a positive edge does exist.  If it was the other way around, maximum bad movement higher than the maximum good movement then it would show that a negative edge existed.  This isn’t necessarily a bad thing as you could use this negative edge entry signal to take the opposite trade (Mean Reversion Strategies).

Random entry would be when the MAE and the MFE are about the same.  For example, if you flipped a coin and heads represented buying and tails represented selling, one would expect after using this type of entry method that the MAE would be equal to the MFE.

To turn this into a solid way of measuring the edge for entry signals, a few more steps are necessary.  First is that you have to have a way to equate price movement across different markets and second, you need a way to determine the time period over which you want to measure the average MFE and the average  MAE.

To organize the MFE and MAE across different markets, CTA’s so that they are able to compare the averages, equate them by using the Average True Range or ATR.  To isolate the market action of entries over various markets, it is useful to be able to compare the price behavior of a specific entry signal using different time frames.

NEXT PAGE: The Formula to Use |pagebreak| Use the following formula below:

• Compute the MFE and MAE for your specified time period.
• Divide each (MFE and MAE), by the Average True Range (ATR), at the time of entry to adjust for volatility.
• Sum-up each of these values separately and then divide by the total # of signals, to get the average volatility-adjusted MFE and MAE.
• The Ratio is the average volatility-adjusted MFE divided by the average volatility-adjusted MAE.

To define the time frame used, use the # of days you used in the description of the ratio, to indicate the # of days over which the component MFE and MAE were computed.  For example, an R10 ratio measurement computes the MFE and MAE for 10 days, including the day of entry, an R50 uses 50 days, etc.

This ratio is used by CTA’s to measure whether their entry signal has a valid edge.  For example, if they tested a random (coin-flip entry), they would probably be looking at results like; a R5- ratio of 1.01, an R10- ratio of 1.005, and an R50 – ratio of 0.997.  These numbers are very close to 1.0, and if they ran more trials, the numbers would get closer to 1.0.  This is the case because the price is just as likely to go in their direction as it is against them after they enter a trade, based on random entry.

To give you an example of this using the Donchian Trend System: The entry rules for this system are simply that one should buy when the price exceeds the highest high of the previous 20 days and sell short when the price goes lower than the lowest low of the previous 20 days.  The results are as follows. The R5- ratio for this sample was 0.99 and the R10- ratio was 1.0.  You might be thinking that the R-ratio should be much greater with a positive edge on your entry signal.  This is true but what you need to keep in mind is that the Donchian breakout system is a medium- to long-term trend following system, so its entry needs to have an edge over these time frames and not the short-term. The R70-ratio for entry is 1.20, which means that trades taken in the direction of a 20-day breakout move on average 20% farther in the direction of the breakout than they do in the opposite direction when one looks at price movement in the 70 days subsequent to the entry signal.  The ratio definitely changes over varying numbers of days and this is one of the reasons trading breakouts can be difficult psychologically.

If you follow or have your own entry method, you should take the time necessary to do the research into what type of edge your entry system has or doesn’t have, in the markets over the time frame you trade, per the above.  If you do, I think you’ll be amazed at some of the results you may find.

By Sherwood Tucker, of Tucker Trading & Consulting