When the author of Market Wizards, Jack Schwager, said, “The hard work in trading comes in the preparation. The actual process of trading, however, should be effortless,” he implied one should focus on how ready one is for the live market.
And by being ready, the most important thing, perhaps, is to have a trading strategy that can withstand the vagaries of the ever-changing markets.
In this context, it is important to quantitatively assess your trading strategy to ensure that it helps you achieve your goal, eliminate emotional biases, and objectively analyze your strategy.
There are multiple metrics traders use to evaluate their trading performance. Most of these parameters are not used in isolation, but in combination.
With little ado, let us look at the 8 key metrics you can use for trading strategy evaluation:
A) P/L Metrics
These metrics focus on the return on your trading capital achieved using your strategy.
1. Wins vs. Losses
The win/loss ratio refers to the ratio of the total number of winning trades to the number of losing trades. This ratio does not factor in the size of the win or loss.
Win/Loss Ratio = Number of Wins/Number of losses
Besides this ratio, it is important to also look at the size of win/ loss and assess the ratio in various market conditions to avoid biases during bull/bear markets.
It also makes sense to look at this ratio with the win-rate, which is the number of profitable trades out of the total number of trades.
A win/loss ratio above 1.0 or a win-rate above 50% is typically preferred.
2. Profit Factor
Profit factor (PF) is the ratio of gross profit to gross loss (inclusive of commissions) for a trading period. This parameter shows the amount of profit per unit of risk.
Typically, a PF of more than 1 is preferred.
PF = Gross Profit/Gross Loss
3. Percentage Profitability
This metric denotes the probability of winning and is essentially the percentage of total trades that turned out to be profitable.
This parameter is calculated by dividing the number of profitable trades by the total number of trades for a specified period.
Percentage Profitability = Profitable Trades/Total Trades
B) Risk Metrics
While looking at returns is important, it is essential to consider risk in your trading performance analysis, i.e. understand the probability of your strategy losing money. Here are some metrics that can help you gauge risk.
4. Maximum Drawdown
Maximum drawdown represents the largest fall in the security price from the peak to a trough over a period. It shows the largest downside risk level or the worst-case scenario of your trading strategy.
Maximum Drawdown = (Trough value – Peak value) / Peak value
Usually, a low maximum drawdown is preferred; however, it must be noted that this metric only measures the size of the largest fall and not the frequency or period for which the strategy underperformed.
5. Annualized Volatility
Annualized Volatility refers to the standard deviation of the daily returns of your trading strategy in a year. Since volatility denotes risk levels, the higher the annualized volatility, the riskier the strategy.
C) Risk/ Reward Metrics
Given that both reward and risk are important elements to examine trading strategy performance, risk/reward ratios can help measure the potential profit of a trade relative to the risk taken. Some important ones are mentioned below:
6. Sharpe Ratio
This ratio measures the average of excess returns to standard deviation. Excess returns refer to your trade’s return minus the risk-free return.
The higher the Sharpe ratio, the better.
Sharpe Ratio = (Portfolio Return – Risk-free Return)/ Standard Deviation
7. Sortino Ratio
The Sharpe ratio penalizes a trader even with upward volatility or upside risk. The Sortino ratio measures returns adjusted for downside risk only.
Sortino Ratio = (Portfolio Return – Risk-free Return) / Annualized Volatility of Negative Returns.
8. Calmar Ratio
Calmar ratio measures the ability of your trading strategy to bounce back from extreme lows. Since it considers maximum drawdown, which denotes the worst-case scenario, Calmar ratio can be a stringent measure of trading performance.
Calmar Ratio = Average (Portfolio Return – Risk-free Return) / Maximum Drawdown
Besides using these metrics for trading performance analysis, it would also be wise to consider factors such as the total costs of trading inclusive of broking charges and taxes, the average holding period which denotes how long your trades last, exposure of your capital to a single trade, and also the number of trades per year, which evaluates the frequency of trading.
Trading performance analysis should also involve using all these metrics in various market scenarios such as trending, volatile, sideways; so you know that your trading strategy works in multiple situations and not just in select or historical scenarios.
PHI 1 offers the bulk backtesting feature to assess your trading strategy with respect to multiple metrics such as ROI and Sharpe Ratio on really large sets of data in a snap.
Also, our grading process grades the risk/return metrics of your strategies in varied market scenarios. Our aim is to ensure that market scenarios should not decide how good your strategy is.
That said, would we ask you to use multiple tools for trading performance analysis? Hell, no!
You may check out some additional metrics to assess trading strategies here – https://www.youtube.com/watch?v=ku6slcFtpOc