By Vic Patel, Forex Training Group
There are many different ways that a trader can measure success in the markets. But some methods are a bit better than others when it comes to evaluating trading performance. In this article, we will discuss 5 key statistics that will give you an objective means by which to assess your trading strategy or system.
Risk Adjusted Returns
If you ask most amateur traders what the most important metric is when it comes to trading performance, they will typically respond by saying that the total return or percentage gain is the most important factor. But if you pose the same question to a professional trader, they will usually respond by saying that the risk adjusted return or gain is the most important factor.
Did you catch the difference? The amateur trader is most concerned with absolute returns while the professional trader understands that absolute returns are meaningless and should be measured against risk. And so, they always prefer risk adjusted performance measures.
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This is an important concept that novice traders should learn sooner than later. Understanding that your overall return as a gauge of trading performance measured in a vacuum without taking into account risk is quite naive and can sometime provide a false sense of security. In the following sections, we will take a look at 5 ways you can measure your trading performance like a professional – based on a risk adjusted basis.
The Sharpe Ratio is one of the more well-known measures of risk adjusted returns. It was introduced by William Sharpe of Stanford University in the mid 1960’s. Essentially, the Sharpe ratio describes how much excess return you receive over the risk-free rate by taking into account the additional volatility that you incur by holding a risky asset. Typically, the 90 day US T-Bill rate is taken as the risk-free rate of return.
The calculation of the Sharpe ratio involves calculating the expect return on your account and then deducting the risk-free rate of return from that. Afterwards you would divide the resulting amount by the standard deviation within the trading account.
Let’s take an example assuming a risk-free return of 4%:
Assuming that within your trading account you are able to achieve a return of 24%, and the standard deviation of your return is 10%, then your Sharpe Ratio would be calculated as follows:
24% (Return Achieved) – 4% (Risk Free Return = 20%
20% / 10% (Standard Deviation) = 2
Sharpe Ratio = 2
In this case, your Shape Ratio would be 2. Typically, a Sharpe ratio of 1.50 and higher is considered a good risk adjusted trading performance.
One of the biggest drawbacks for the Sharpe Ratio is that it does not distinguish between upside volatility and downside volatility, meaning that it penalizes both negative volatility from losing trades, as well as positive volatility occurring from winning trades.
Some trading strategies, especially trend following strategies are prone to a having a lower win percentage, but the average winning trades can be many multiples of the average losing trades. When we are evaluating trading performance for this type of system or strategy, the Shape ratio does not provide the best reflection of trading performance.
The Sortino Ratio aims to address this inherent flaw with in the Sharpe Ratio. The Sortino Ratio uses the same calculation as the Shape Ratio but with one important difference. The Sortino ratio only takes into consideration the downside volatility of the negative returns and does not consider the upside volatility of the positive returns. This creates a better more accurate risk adjusted measure of trading performance. As with the Shape Ratio, the higher the number the better the risk adjusted trading performance. A Sortino ratio of 1.50 and higher is considered good.
The Calmer Ratio is one of my favorite trading performance metrics. It is the one that I tend to put the most amount of weight into when evaluating my own trading performance as well as when I am evaluating the performance of CTAs and Hedge funds.
The Calmer Ratio is calculated by taking the average annual compound rate of return and then dividing that by the maximum drawdown incurred over the same time horizon, typically 3 years. If, however, 3 years of data is not available, then you would simply use the maximum amount of time that data is available for your trading strategy.
Let’s take an example:
If you have been trading for 3 years using a particular trading strategy, and the average annual compound rate of return that your strategy has achieved over this period is 36%, and the maximum drawdown that you have experienced during the same periodic is 20%, then your Calmer ratio would simply be calculation as:
36% (3 Year Avg. Return) / 20% ( 3 Year Max DD )
= 1.80 Calmer Ratio
The higher the Calmer ratio the better the risk adjusted return. Usually you want to have at least a 0.50 Calmer ratio in your trading program. Anything over 1 is considered a pretty healthy risk adjusted return.
One of the simplest measures of trading performance is a metric called Profit Factor. Though it is simple enough for any trader to understand and utilize, it is one of the most effective ways to quickly gauge your trading performance. So how it is calculated?
Profit Factor is determined by taking your gross profits and dividing it by the gross losses. That’s all there is to it. So, let’s say that you want to evaluate your trading performance based on Profit Factor over the course of the last one year period. Here’s how you would do it.
You go back into your records and find that your total gross profits for your trading strategy was $ 82,000 and your total gross losses for the same period was $ 51.000. Based on this, you can figure out what your Profit Factor was. You simply divide your gross profit of $ 82,000 by your gross loss of $ 51,000 to arrive at a Profit factor of 1.60. Generally, a profit factor above 1.25 is acceptable, and anything above 1.75 is considered very good.
Profit Factor is one trading strategy metric that every trader should know. It is easy to understand and calculate, and it provides a quick and valuable snapshot into the efficiency of your trading performance.
Gain to Pain Ratio
The Gain to Pain Ratio was popularized by Jack Schwager and introduced in his book “Hedge Fund Market Wizards”. It is a risk adjusted performance metric that is somewhat similar to Profit Factor but with a bit of a twist.
The Gain to Pain ratio is computed by taking the sum of all monthly returns and dividing that by the absolute value of the sum all monthly losses. Let’s take a look at an example.
Let’s assume that over a course of one year, the sum total of all your total monthly returns equals 40%. And let’s say that you have 4 losing months within that 12 month period where you lost 5%, 3%,7%, and 4%. The absolute value of the sum of these four monthly losses is 19%. Based on this we would divide 40% by 19% to arrive at 2.10, which would be the Gain to Pain Ratio for your trading strategy over the last one year period.
A Gain to Pain ratio above 1.25 is considered good, and a value over 2 is very good.
So now you should be more familiar with risk adjusted returns, and understand why using this type of trading performance metric is important when evaluating your own trading results. You don’t necessarily need to memorize or refer to each one that we have mentioned thus far, but you should pick at least one or two that you are comfortable and use that as your go performance metric.
This is a guest post by Vic Patel of Forex Training Group, a trading education blog that provides in-depth analysis related to the currency markets.