Way of the turtle

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Way of the Turtle
Good vs. Bad Price Movement
Buy
Buy
Good Price Movement
Bad Price Movement
Figure 5-1
Good versus Bad Price Movement

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To isolate the behavior of entries over various markets, it is use-
ful to be able to compare the price behavior of an entry signal
across different time frames. I usually examine a specific number
of days and then measure the MFE and MAE for that number of
days after each signal is generated. At Trading Blox, where I head
Research and Development for a sophisticated system-testing envi-
ronment, we have implemented an entry edge measure we call the
E-ratio (short for edge ratio). 
The E-ratio combines all of the pieces described above by using
the following formula:
1. Compute the MFE and MAE for the time frame specified.
2. Divide each of them by the ATR at entry to adjust for
volatility and normalize across markets.
3. Sum each of these values separately and divide by the total
number of signals to get the average volatility-adjusted MFE
and MAE.
4. The E-ratio is the average volatility-adjusted MFE divided
by the average volatility-adjusted MAE.
To define the time frame, we use the number of days in the
description of the ratio to indicate the number of days over which the
component MFE and MAE were computed. For example, an E10-
ratio measurement computes the MFE and MAE for 10 days, includ-
ing the day of entry; an E50-ratio uses 50 days, and so on.
The E-ratio can be used to measure whether an entry has an
edge. For example, you can use it to test whether a completely ran-
dom entry has any edge. To illustrate, I ran a test of the E-ratio for
the period of the last 10 years by using an entry that randomly
Trading with an Edge
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67

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enters long or short at the open, depending on the computer equiv-
alent of a coin flip. The average of 30 individual tests showed an
E5-ratio of 1.01, an E10-ratio of 1.005, and an E50-ratio of 0.997.
These numbers are very close to the 1.0 we would expect, and if
we ran more trials, the numbers would get closer and closer to 1.0.
This is the case because the price is just as likely to go against a
position as it is to go in a direction favorable to a position over any
reasonable time period.
You can also use the E-ratio to examine the major components
of the Donchian Trend system. The two major components of the
entries for this system are a Donchian channel breakout and a trend
portfolio filter. The Donchian channel breakout is a rule that states
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 trend portfolio filter means
that you can initiate long trades only in markets in which the 50-
day moving average is higher than the 300-day moving average and
can initiate short trades only in markets in which the 50-day mov-
ing average is lower than the 300-day moving average. One of the
roles of the portfolio filter is to eliminate markets that are not in a
market state favorable to this system.
Let me show you how to use the E-ratio to examine the trade-
entry rules for the Donchian Trend system. All the tests described
below were performed by using a set of 28 high-volume U.S. futures
markets, employing data from January 1, 1996, to June 30, 2006.
The E5-ratio for our sample is 0.99, and the E10-ratio is 1.0. “Wait
a minute,” you might say. “I thought that the E-ratio would be greater
than 1 when an entry had a positive edge.” This is true. However,
remember that we need to consider that the Donchian channel