The Sharpe ratio heuristically characterizes the reward/risk ratio of the strategy. It quantifies how much return you can achieve for the level of volatility endured by the equity curve. Naturally, we need to determine the period and frequency that these returns and volatility (i.e. standard deviation) are measured over. A higher frequency strategy will require greater sampling rate of standard deviation, but a shorter overall time period of measurement, for instance.
Maximum Drawdown
The maximum drawdown is the largest overall peak-to-trough percentage drop on the equity curve of the strategy. Momentum strategies are well known to suffer from periods of extended drawdowns (due to a string of many incremental losing trades). Many traders will give up in periods of extended drawdown, even if historical testing has suggested this is “business as usual” for the strategy. You will need to determine what percentage of drawdown (and over what time period) you can accept before you cease trading your strategy. This is a highly personal decision and thus must be considered carefully.
Volatility
Volatility is related strongly to the “risk” of the strategy. The Sharpe ratio characterizes this. Higher volatility of the underlying asset classes, if unhedged, often leads to higher volatility in the equity curve and thus smaller Sharpe ratios. I am of course assuming that the positive volatility is approximately equal to the negative volatility. Some strategies may have greater downside volatility. You need to be aware of these attributes.
Win-Loss Ratio
Technically, this is the ratio of the average losing trades and the average winning trades. This ratio gives a commendable idea on tradability and helps you identify if you’re on the right track. If the ratio indicates that you’re winning more than you’re losing, you’re doing a good job. However, one limitation here is that you cannot totally take this metric as a fool-proof approach because it doesn’t indicate the size of your winning and losing trades, which is crucial in assessing the performance of your trade.
Expectancy
When it comes to metrics on trading performance, expectancy is one of the most efficient and powerful metric because it estimates a return for every amount of cash risked in a trade. In short, it shows you how much returns you can expect for the sum you’ve invested on trading on a particular instance. Often, there is a lot of misconception among expectancy of a trading system and average wins to losses and reward:risk ratio. But what makes expectancy distinct lies in the fact that it quantifies the performance of a system independent of trading capital.
Originally published at auquan.com on February 1, 2017.
