How to Measure the Performance of a Trading Strategy
Defining a Quantitative Trading Strategy and Trading Signal – Introduction
There is the popular phrase “if your goals can’t be measured, you need to change them”. This more concretely means that you will never know when the point at which you reached your goals has arrived because you can’t measure them the right way. The same goes for trading. You can invent the best, never seen strategy, but it is worthless if its performance can’t be measured. It is especially important since it is one of the most powerful ways to show you how and when to correct your plans. There are many ways to measure the performance of your strategy. We will explain some of them.
The Equity Curve Versus Benchmark
In this approach you are measuring your trading performance with three factors: expectancy, risk of ruin, and the recovery rate.
Expectancy is an approximation of your average earning per trade. In other words, it will show you how much you will earn on average per individual trade. The things that you need to know for this calculation are the win rate, the reward risk ratio, and the average position size. The formula is:
E= (W*R*A) – ((1-W)*A)
The symbols are:
E – expectancy
W – win rate
R – reward risk ratio
A – average position size
The result of this equation is the expectancy of approximately how much each trade will be worth.
Risk of ruin evaluates how likely your strategy will lead to ruin, or what is the probability and influence of the risk that can occur during the trade. This factor can also help you find the best strategy for you or even to change your strategy if the current one could lead to a disaster. For example, if you are using the traditional strategy which considers 60% invested in equity and 40% in bonds, it is clear that the majority of the risk lies in the equity trades and you should therefore be more careful with them. When this calculation shows how big the risks are and you are underachieving, you should try a different strategy, such as the AQR which will distribute your risk equally across your trading portfolio.
The recovery rate shows you how long and how much you need to recover if you suffer losses. It can use the highest point or the starting point. Its main purpose is to show you how much you need to the point of breaking even (from any of the mentioned points) when you start suffering losses.
The Trading Signal
The usual thing that you will do is to express it with percentages. This way you can always clearly see it on a graph and spot problems with your strategy. But beware, sometimes percentages can be deceiving. Percentages only show the thing you are measuring. They don’t show conditions and other factors around it, which can sometimes be crucial. Percentages won’t show you the size, frequency, nor correlations among your assets. They will only show you the criteria for which you did the calculation, so bear that in mind.
Speaking of percentages, some popular investing metric ratios used all over the financial world are the Sharpe and Sortino ratios.
The Sharpe ratio
This ratio combines the analyses of the risk of trading with the volatility of the account growth. The main thing that you need to know is that the higher it is, the better your strategy is. If your Sharpe ratio is high, you have a good relation of risk and possible drawdown = your risk won’t bring you anywhere near disaster. A high Sharpe ratio also means that your account was less volatile in the past, which is also an excellent thing.
The Sortino ratio
This ratio represents the expansion of the Sharpe ratio. If the Sharpe ratio only analyzes the risk and its consequences, the Sortino ratio also takes into account the possibility of that risk growing and how it will reflect on your performance. It also works as a “policeman” whereby it penalizes a strategy with the possibility of exponentially high risk with a low level of return.
Both of these ratios are good, but if you have to choose, it is better to use the Sortino ratio because it will show you a clearer picture of your strategy. But bear in mind that for the best measuring performance it is recommended to use both of them.
Measuring with goals
There is always the empiric method where you can measure your performance not metrically, but with the goals you set. This method is based on comparing your goals with the results you have achieved at some point. If the results are satisfying and match your goals, continue with the strategy. If the results are short of your goals, think about changing the strategy. Even if this method looks the easiest to use, you should always do some metric and quantitative measuring since this is usually solely based on the intuition which can be deceiving.
You can clearly see that measuring your performance is one of the most important things in the trading business. There is a famous method called the DMAIC cycle (define, measure, analyze, improve, control) which was used by Toyota to become a world leader in lean and economical production. In this acronym M stands for measure, which means that measuring is a very important part of any process. There are a lot of metric and other methods for measuring. You should always have one or two up the sleeve to use at any time, because you never know where your strategy can lead you.