wrong path for the immediate future. In trading, we are blessed
with a loud, clear alarm: losing money. Even though it’s easy to
count and losses are reported by vast arrays of equipment second
by second, losses remain tough to acknowledge. Just as it was
tough when we were children to look under the bed or in a dark
closet for night monsters, it’s equally tough to look at a loss and acknowledge
it. It was easier to hide under the covers back then, and
now it’s easier to adopt some defense mechanism. (The one I hear
the most is “Oh, that trading rule doesn’t work!” as if the entry
strategy caused the loss.) To conclude, it’s necessary to actually
define and measure exactly what we fear: losing money.
In this article, we actually gather information on how bad things
get during our trades. We’ll determine whether there’s any pattern in
the bad news-whether there’s a difference between the pattern of
losing trades and the pattern of winning trades, If there is a pattern,
can we exploit it? Wouldn’t knowing how much adverse price movement
we were in for tell us how far to hold on? And wouldn’t knowing
the size and frequency of our losses tell us how much money
we’d need to trade a given scheme?
What about the formal definitions of risk? Although I was
trained to use them, academic definitions of risk don’t define the
element we fear: losses. Variance is an excellent theoretical construct
and commendably tractable mathematically, but the fear we
have deals only with the downside of variance, not the upside. So
let’s look at the downside in depth.
Measuring Losses
Our operational problem is that, at some point, we must cut our
loss, That point could be defined by time, by variables (other data
series, judgment, or politics) independent of price, by portfolio
constraints, or by financing, but usually the limit is set by the price
itself. The one thing of which we are relatively sure is the price at
any given moment irrespective of what is driving it. Because price
is what drives our loss and we can track price, let’s just measure
how bad the price movement is during our winning trades, Then
let’s ask how bad it gets during a losing trade.
If we know anything about winning trades, it’s that they end up
in the black. Do they get there randomly? That is, are they at a loss
one moment and, erratically, at a profit the next? This isn’t our general
experience (though it may seem so in the heat of an individual
situation). Trades that are winners rarely go from being deep losses
to overnight winners. So, if winners don’t become winners erratically,
is there some order to their performance?
It turns out there is. If you measure the worst price move against
your position, there is a difference between that movement for winning
trades and that for losing trades. Specifically, winning trades
just don’t have as much adverse price excursion as losing trades.
Excursion
I choose the word excursion pointedly because, throughout this
book, I’m most interested in what the price does&m rhe point of
entry. I want to look at the market’s behavior in the awe of my
trading action. Excursion is a neutral term that conveys neither direction
nor amplitude, simply movement. Excursion also conveys
that, because we don’t know where price is headed, our unbiased
expectation is that price will return to where it started-our entry
price.
We don’t know whether there will be movement after our entry
or, if there is to be movement- where, when, or how much. Excursion
captures this ignorance well and, having acknowledged it, allows
us to study price movement rather than ignore it.
Furthermore, when we find prices moving away from our expectation,
we have evidence to suspect that something other than
“noise” is causing the motion. That is, the more prices depart from
our previous expectation that they would be the same tomorrow
(or perhaps oscillate lightly around today’s price), the more evidence
there is that our expectation was wrong and the more opportunity
for profit from price change.
For now, note only that price excursion can be favorable or unfavorable,
hence terminology you’ll see later: favorable excursion or adverse’ excursion.
What Is Maximum Adverse Excursion?
Maximum adverse excursion is the worst intraday price movement
against a position at any time during the trade. For the purposes of
testing, this is the high or the low of the day, keeping in mind the
vagueness of these reported figures. These numbers usually have
been touched only momentarily; sometimes, the actual number is
even outside the reported number, which should give you some
pause when relying on them.
Read More : Handling the Bad Trade
