Way of the turtle

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Way of the Turtle

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versely, it is possible to have an exit signal that has an edge for long-
term systems but not for the short term. Some concrete examples
will help demonstrate this effect.
The Edge Ratio (E-Ratio)
When you are examining entry signals, you care about the price
movement subsequent to the occurrence of the market actions that
constitute the signal. One way to look at this movement is to break
the price movement into two parts: the good part and the bad part. 
Good price movement is that which progresses in the direction
of the trade. In other words, when you buy, it’s good when a mar-
ket moves up and bad when it moves down, and when you sell
short, it’s good when a market moves down and bad when it moves
up. Consider the case where a buy results in a price that initially
moves in a direction that is bad for the trade, the price goes down;
then it goes up and moves to a price higher than the entry price for
the trade; after this move down, the price moves up for a while and
then goes down again, as shown in Figure 5.1. 
Traders refer to the maximum move in the bad direction as the
maximum adverse excursion (MAE) and the maximum move in the
good direction as the maximum favorable excursion (MFE). Thus,
the lines with the double arrows in the figure show the size of the
MAE and MFE for the price move indicated. Figure 5-1 demon-
strates the case where the MFE (good price movement) is much
higher than the MAE (bad price movement).
You can use these to measure the edge of an entry signal directly.
If a certain entry signal generates a move in which the average max-
imum good movement was higher than the average maximum bad
Trading with an Edge
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65

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movement (i.e., the average MFE was higher than the average
MAE), this would indicate that a positive edge existed. If the aver-
age MAE (adverse movement) was higher than the average MFE
(good movement), this would indicate that a negative edge existed.
One would expect that a truly random entry would result in approx-
imately the same good movement as bad movement. For example,
take the case in which one bought if a coin landed heads up and
sold if it landed tails up. One would expect that the price move-
ment subsequent to this type of entry would have an MFE equal
to its MAE.
To turn this way of thinking about an edge of an entry into a
concrete way of measuring the edge for entry signals, it is neces-
sary to add a few more steps. First, you need a way to equate price
movement across different markets. Second, you need a way to
determine the time period over which to measure the average
MFE and average MAE. To normalize the MFE and MAE across
markets so that you can compare the averages meaningfully, you
can use the same mechanism the Turtles used to normalize the
size of our trades across markets: equating them by using the aver-
age true range (ATR).