Edge Ratio (E-Ratio)

Edge ratio (or E-ratio) is a metric used in trading and finance to quantify the profitability of a trading strategy or entry point. 

It essentially measures how much a trade moves in your favor compared to how much it moves against you.  

Key Takeaways – Edge Ratio (E-Ratio)

• Edge Ratio = (Normalized MFE) / (Normalized MAE)
  • Maximum Favorable Excursion (MFE) – The largest potential profit reached during the trade before exiting.
  • Maximum Adverse Excursion (MAE) – The largest potential loss reached during the trade before exiting.
  • Normalize MFE and MAE – Divide both MFE and MAE by the Average True Range (ATR) at the trade entry.
• Quantifies edge – Measures favorable vs. unfavorable price movements to objectively assess trading strategy profitability.
• Optimizes exits – Helps determine profit targets and stop-loss orders by analyzing price excursion tendencies.
• Aids strategy development – Used in backtesting to identify and refine robust, profitable trading approaches.

Edge Ratio Explained

Here’s a breakdown of what edge ratio is and how it works:

Concept

Imagine you enter a trade.

The price will fluctuate, sometimes going in your favor (increasing your profit) and sometimes going against you (increasing your loss).

The edge ratio measures the balance between these favorable and unfavorable movements.

Calculation

• Maximum Favorable Excursion (MFE) – The maximum profit the trade reached before exiting.
• Maximum Adverse Excursion (MAE) – The maximum loss the trade reached before exiting.
• Normalization – Both MFE and MAE are normalized by the market volatility (usually measured by Average True Range (ATR)) at the time of trade entry. This makes the ratio comparable across different markets and time periods.
• Edge Ratio – Calculated as the normalized MFE divided by the normalized MAE.

Interpretation

• A higher edge ratio indicates a more profitable trading strategy or entry point.
• An edge ratio of 1 means the favorable and unfavorable movements are equal.
• An edge ratio greater than 1 means the trade moves more in your favor than against you.
• An edge ratio less than 1 means the trade moves more against you than in your favor.

Benefits of Using the Edge Ratio

Quantifiable edge

It provides a numerical measure of your trading edge, allowing you to compare different strategies or entry points objectively.

Optimal exits

It can help you identify optimal exit strategies.

For example, a high edge ratio with mediocre closed-trade metrics might suggest you’re giving back profits.

This might indicate the need for a profit target.

Risk management

A low edge ratio may indicate the need for tighter stop-loss orders to reduce potential losses.

Strategy development

Edge ratio can be used in developing and backtesting trading strategies to identify robust and profitable approaches.

Limitations

Past performance

Like any metric based on historical data, edge ratio doesn’t guarantee future profitability.

Markets can change, affecting the effectiveness of a strategy.

Over-optimization

For quants, focusing solely on maximizing edge ratio can lead to over-optimized strategies that perform poorly in real trading.

Subjectivity

The calculation of edge ratio involves some subjective choices, such as the volatility measure and lookback period used.

Conclusion

Overall, edge ratio is useful for traders and investors to help understand the profitability of their strategies and make informed decisions.

It’s nonetheless good to use it in conjunction with other metrics and consider its limitations.