e-ratio is a metrics that measures the edge of a trading system component. For example, we could use it to quantify the edge gained from a donchian channel breakout entry signal.
The e-ratio quantifies the edge by calculating the overall amount trades go in your favor versus the overall amount trades go against you. The higher value the value of the e-ratio, the more trades move in your favor – giving you a good indication of the edge measured.
Take all the trades generated by the entry signal.
Close each trade after a given duration of n days.
Calculate the e-ratio based on data from all trades (formula detailed in 4 steps below). This gives you the e-ratio for a trade duration of n days.
Repeat the operation for various values of n to chart the e-ratio curve as a function of the number n of days – as illustrated below:
Step 1: Record MAE and MFE for each trade
For each trade, measure the Maximum Favorable Excursion and the Maximum Adverse Excursion.
Maximum Excursions are the maximum amount the price goes against you (Adverse) or in your favor (Favorable) during the trade. MAE is calculated between the entry price and the lowest price during the trade. MFE is calculated between the entry price and the highest price during the trade. Note that both values are positive.
Step 2: Normalise MAE and MFE values
To be able to compute the e-ratio across different markets, the Excursion values should be normalised to a common denominator – such as a unit of volatility. The Average True Range is a good measure of volatility. In many systems it is also used to drive the position sizing, making it really relevant.
Divide all MAE and MFE values by the ATR calculated at the beginning of the trade. In this example we use the same period for the ATR and the Donchian Channel.
This gives you comparable values across all markets and conditions.
Step 3: Average MAE and MFE values across all trades
Simple maths here: just add all normalised MAE values calculated in step 2 and divide by the number of trades. Repeat the operation for the MFE values.
Step 4: Final division = e-ratio
Simply divide the average MFE by the average MAE to give you the e-ratio. The higher the number, the better, with any values above 1 implying a positive edge.
Plotting the e-ratio across different durations allows you to check the edge offered by the signal and what timeframe works best for the signal parameters.
You can also combine e-ratios for different parts of a system to see how they impact each other.
Another component of a trading system could be a trade filter, for example, trade with the main trend:
The e-ratio is one tool in the box of an automated trading system developer. It can quickly give you an overall feel for a component to include in the trading system
Credits: e-ratio was introduced to me by Curtis Faith in his Way of the Turtle book.
Note: The e-ratio was calculated using TradersStudio (and Excel). The system tested was a Donchian Channel Breakout (17 days) with 7 Futures markets. The MA used for filtering was 108 days. I will follow-up with a post containing the code used to calculate it.