The importance of strategy evaluation cannot be stressed enough in the trading context. Trading strategy evaluation has obvious benefits such as better risk management, refining your strategy, placing live trades more confidently, and avoiding huge losses.
Given the plethora of advantages and easy-to-use tools at your disposal, it makes little sense not to test your strategy prior to actual trading.
Let us look at some methods you can use to evaluate your trading strategy.
1. Choose a benchmark to assess the relative performance of your strategy
After you have devised your trading strategy, you need a benchmark to compare the relative performance of your strategy. Choose a benchmark that applies to the sector or market you are trading in. For example, if you are trading a stock like Infosys, having the Nifty IT index as a benchmark would be a wise choice.
Comparing your trading strategy’s performance vs. that of a benchmark can help you understand relative performance and develop confidence in your trades.
For example, let’s say your benchmark has returned a negative 2% annualized performance and your strategy has delivered a +1% annualized return. This tells you that your strategy has outperformed the benchmark.
2. Consider risk-adjusted returns
So, you have two strategies X and Y which may have given you the same returns over a specific period. However, strategy Y may deliver the returns with much more volatility/risk vs. strategy X. This implies that X delivers better risk-adjusted returns than strategy Y. Why would you take more risk to get the same return? Clearly, X is better.
To measure risk or volatility, you can use the standard deviation of returns.
Using a measure such as Sharpe Ratio can help you assess your strategy with respect to risk-adjusted returns.
Sharpe Ratio = (Return – Risk-free Rate)/ Standard Deviation of Returns
Remember, the higher the Sharpe ratio, the better.
However, Sharpe ratio can mislead as it does not consider the direction of volatility (upward volatility may not always be unfavorable). This is because more risky strategies will always rank lower with this ratio.
An alternative ratio in this case can be the Sortino ratio, as it only considers standard deviation of downside returns. Thus, it does not penalize upward volatility as in the Sharpe ratio.
3. Check Profit/ Loss performance alongside ratios
It is not always a great idea to use ratios in isolation. It always pays to use charts such as P/L in various market scenarios to assess your trading strategy.
Check how the strategy will perform or has performed not just during bull phases but also during bear markets and market crashes.
4. Use Maximum Drawdown
Maximum Drawdown is the distance between the largest peak to the lowest valley of your P/L. Maximum drawdown measures the biggest movement from a high point to a low point prior to a new peak.
Thus, it essentially measures the size of the largest loss, an indicator of downside. It focuses on capital preservation and should be as low as possible. Maximum drawdown can measure risk-adjusted returns using the Calmar Ratio.
However, it must be noted that it does not denote the frequency of loss or size of gains.
Calmar Ratio = Average Return/Max Drawdown
5. Assess metrics such as Win Rate, Average Size, and Average Profit/Loss – all together
Estimating other measures such as win rate, number of wins and losses, and average profit and loss over a specified period, when taken together, can reasonably show how your strategy has worked.
6. Backtest and forward-test using extensive sets of data and multiple scenarios
Finally, when you use backtesting to examine your strategy, the results depend on how reliable your data and model are. Most times, over-fitting (which refers to designing a trading system to adapt too closely to historical data) can give you false confidence that your trading strategy is robust.
Therefore, it is important to test your strategy in a wide range of market scenarios such as crash, choppy, sideways,. and to use extensive sets of data and instruments. Consider forward-testing your strategy in different simulated environments as well.
To evaluate your trading strategy well, you need backtesting and forward-testing capabilities that allow you to test with reliable and large sets of data in all market conditions.
Now, if you’re wondering where to get such strategy evaluation tools, you’re already there! PHI 1 allows bulk-back testing on vast sets of data in a matter of minutes and in different market scenarios like trending, choppy, sideways, crash.
In fact, we have a unique scenario grading process (patent pending) that assesses your strategy in multiple market scenarios – all this on one platform!