It’s obvious that being a trader, you’ll be looking for ways to make profits out of your trade and finding out the best practices and tips to become a profitable trader. We understand that and that’s why we’ve discussed some crucial approaches to evaluating the performance of your trade.
Creating Metrics to Measure Performance
These are some of the most basic metrics or parameters that will help you gauge the performance of your trades and will help you identify the weaknesses and strengths in your trading.
Some widely used metrics are:
- Annualized Return: The yearly average % Profit(or Loss) from your trading strategy
- Annualized Volatility: The standard deviation of daily returns of the model in a year. Volatility is used as a measure of risk, therefore higher vol implies riskier model.
- Sharpe Ratio: The reward/risk ratio or risk adjusted returns of the strategy, calculated as Annualized Return/Annualized Volatility
- Sortino Ratio: Returns adjusted for downside risk, calculated as Annualized Return/Annualized Volatility of Negative Returns
- Max Drawdown: Largest drop in Pnl or maximum negative difference in total portfolio value. It is calculated as the maximum high to subsequent low difference before a new high is reached.
- Win/Loss, Average Profit/Loss: Sum(or Avergae) of Profits from trades that results in profits/Sum(or Average) of losses from trades that results in losses
- % Profitability = % of total trades that resulted in profits
Read more about these metrics in our post on Trading Metrics.
Proper Accounting of Costs
One of the other important approaches to evaluating trading strategies is properly account the costs involved. As a beginner, a common mistake that you would tend to do is ignore the transaction costs involved in a strategy. A lot of quants assume that only commissions to brokers reflect on the transaction costs of a trading strategy. However, there are a few more factors to it. Some common examples of trading costs are:
Commissions
As you know that it’s really difficult to trade without an intermediary known as a broker. Acting as an exchange, brokers offer transactional services and get paid commissions in return. But what come as added expenses are fees that brokers sometimes, charge for additional services, exchange mandated costs and any government tax that get imposed on the financial transaction.
Slippage
A key aspect that often goes unnoticed as an evaluation factor is slippage. Any difference between the price that you wanted to trade at and the price you actually end up trading is called slippage.
Why is there a difference in these prices? There can be many factors. For example, you maybe wanted to buy a 100 shares of AAPL at 100$, but only 50 people were selling at 100$, and 50 more at 101$. The price you traded at is 100.50 and your slippage is 50 cents.
A component of transaction costs, slippage can efficiently differentiate between a profitable strategy from the one that can perform poorly. In the previous example, if you planned to sell your shares back at 102$, you’ve reduced this profit by 25% thanks to slippage! However, slippage can easily be minimized by building an efficient execution system.
Personal Biases
Everything starts from within and by everything we mean both profit and loss. Though the market and its volatility are crucial in determining how much profit or loss we’re going to hit, there’s always a voice within that guides us through in a trade. Sometimes, these voices can be helpful; but mostly, these are personal biases. Often, such personal biases drive us through a range of emotions and make us take decisions we weren’t supposed to in the first place. Such personal biases are emotions we need to discipline to know when to stop and when to proceed with a trade.
Our decision making abilities are stalled by a number of emotions and so are crucial parameters to evaluate a trading strategy. Some of the emotions that cloud our minds include excitement, thrill, optimism, fear, anxiety and panic. Since these are the driving emotions, a check on them at the right time will always help us increase the performance of a trade for the better.
For more on this, we’ve also have a resource on biases in backtesting and risk management. This will give you further insights on personal biases and how you can stay away from them for a better trade.
These are some of the most common parameters on evaluating a trading strategy. Understand them and try implementing them on your strategies and make notes. Assess the results and tweak to further boost the performance of your trade.
Originally published at auquan.com on January 31, 2017.
