## 8 Metrics to effectively evaluate your trading strategy performance

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.

### 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!

PHI 1 can give all of this and more on a single, unified platform. Go check it out for free!

You may check out some additional metrics to assess trading strategies here

## How to evaluate your trading strategy to reduce your losses

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!

If you want to try out these features, simply visit app.phi.io and enjoy our free 14-day trial.

You can also avail a quick demo. And once you’re convinced (which we have no doubt about), check out our reasonably priced plans here.