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part 2 continues
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Once we know the amount of heat we can endure we must decide on how we will
measure the performance of the trading logic. Below is a list of the
common, and not so common indicators. However, what determines what a
"good" value is for these indicators will depend largely upon the traders
answers to the above questions. Here is a summary list. The minimum
performance levels are based on trading a 1 lot S&P on a 3 minute chart,
and doesn't account for slippage or commissions (as this seems to be the
standard practice):
1. Net Profit per Trade (Avg. $ per Trade) $ 200 minimum
2. Profit Factor (Gross Profit/Gross Loss) 2.0 minimum
3. Drawdown/Run-Up Analysis
4. Sharpe Ratio 4.0 minimum
5. Total Trades 2-6/day max
6. Total number of Longs/Shorts Ratio ~1:1
7. Total Net Profit n.a. -
subjective
8. Average Winning Trade
9. Average Losing Trade
10. Average Win To Average Loss Ratio Depends on % winners
11. Largest Loosing Trade/Average Win Ratio 1.5 or lower
12. Largest Drawdown/Average Win Ratio 7.0 maximum
13. Average Drawdown/Average Win 1.0 Maximum
14. Percent of Winning Trades n.a. - subjective
15. Max. Consecutive Winning, & Loosing Trades n.a.
16. Average Number of Winning, and Loosing Trades
Gross Profit per Trade (GPT)
Calculation: Total Profits divided by Total Trades
This number is perhaps the most important because it tells us the average
profit we can expect to make on each trade. Each trade will generate two
associated cost; slippage, and commissions. Should the GPT be low then
slippage will change a profitable system to a loser. The higher this number
the better. It is important to realize that when commissions AND Slippage
are factored in many systems fall apart because this number is not higher
than actual cost. Generally this number should be twice the expected amount
of slippage - plus the commissions cost - for the S&P $200.
Profit Factor
Calculation: Total Profits divided by Total Loss
This number will tell us the amount of profit we gain for every dollar
placed at risk. Generally we want to risk $1 for the possibility to gain at
least $2 dollars.
Drawdown Analysis - Consecutive Losing Periods
1. Determine the percentage of money lost (maximum)
2. Identify the length that it took to hit this maximum percentage loss.
3. Identify how long it took for the Recovery to take place.
4. The Peak is the time frame just before the drawdown began, or the Start
Date (which is one time frame less).
5. The Valley is the time frame that the worst percentage loss was experienced.
6. Identify the maximum amount of money lost.
7. If not using time to identify length of drawdown then determine the
number of trades before the equity is restored.
Run-Up Analysis - Consecutive Winning Periods
1. Determine the maximum percentage of money made in the Run-up.
2. Identify the Start date the winning streak began.
3. Identify the End date of the winning streak.
4. Identify the length of time that it took to hit this maximum percentage
gain.
5. Identify the maximum amount of money gained.
6. If not using time to identify length of run-up then determine the number
of trades before the equity is begins to decrease.
Generally we want to avoid any systems that experience more than a 30% loss
of capital. We must totally avoid systems that generate 50% or more of a
drawdown as it becomes almost impossible to recover from such a large
reduction in ones equity. In judging the length of a drawdown to endure it
is generally best to look for a system where the total length of the
longest drawdown is no more that twice as long as the total length of the
largest run-up. This is a subjective rule and is totally dependent upon the
trader and the amount of pain he can take.
Sharpe Ratio
The ratio is based upon comparing the standard deviation of the system
returns and the amount of risk of that system - to the amount of return
that could have been earned in a risk free investment. Generally the higher
the Sharpe Ratio the better the system. The Sharpe Ratio is a good way to
compare different strategies as it levels the playing field. Again this is
a subjective evaluation however generally I would like to see a value of 4
or higher.
Total Trades
The concept is simple; can the trader actually trade the system? How many
trades a day (or whatever unit of time the trader wants to use) is the
trader comfortable with? How easy is it to execute the trades? Is the
execution method reliable? Generally I like 4-6 trades per day, however
this is dependent upon the trader.
Total Gross Profit
Calculation: Total Profit less Total Loss
This number is totally dependent upon the trader. Largely depends upon if
the trader is trading full or part time. Must he trade to pay the bills? If
so, then the total net profit required will be dependent upon the traders'
lifestyle. This doesn't include commissions or slippage.
Average Winning Trade
Calculation: Total Gross Profit divided by total winning trades.
This number tells us the average amount of profits per winning trade.
Average Loosing Trade
Calculation: Total Gross Loss divided by total loosing trades.
This number tells us the average amount of loss per loosing trade
Average Win To Average Loss Ratio
Calculation: (Total Profits divided total number of winning trades) divided
by (Total Loss divided by total number of losing trades).
This ratio is based upon the average gain of winning trades, and the
average loss on the loosing trades. While it seems similar to the NPT or
Profit Factor it is not. This is because the other primary variable is the
percentage of winning trades. With this ratio we can have a profitable
winning system that will generate larger loosing trades than winning
trades. The reason this is profitable is because the percentage of winning
trades is more than 50%. Generally I want to see at least 2.5 or more -
250% more average gain than loss.
Largest Loosing Trade/Average Win Ratio
Calculation: Largest Loss divided by Average Profit per winning trade.
This ratio will indicate approximately how many winning trades it will take
to recover from the largest losing trade. Generally a value of 4 or less
is good, I prefer 1.5 or better. As this is telling us that with 4 (or 1.5)
average winning trades we will recover from the largest historical loss.
Again this relates to the amount of pain a trader can endure.
Largest Drawdown/Average Win Ratio
Calculation: Determine amount money lost in the largest Drawdown divided by
the Average Profit per winning trade.
This ratio will also give us an indication of the amount of pain that must
be endured. We will know the approximate number of winning trades it will
take to recover from the largest historical drawdown. When combined with
percentage of winning trades we can then begin to estimate how many trades
overall must be traded. Generally I do not want to see a ratio above 7.0.
In other words this is telling me that in 7 winning trades I should recover
from my drawdown.
Average Drawdown/Average Win Ratio
Calculation: Determine the average amount money lost in the all of the
Drawdown's divided by the Average Profit per winning trade.
Similar to the previous ratio we will know the approximate number of
winning trades it will take to recover our lost equity. When combined with
percentage of winning trades we can then begin to estimate how many trades
overall must be traded. Generally I want the value to be no higher than 1.0.
Percent Profitable
Calculation: Total number of trades divided by total number of
winning trades.
This ratio relates to the number you times you can make a losing trade
without getting upset or doubting the integrity of trading logic. In my
opinion it is the least important of the ratios in determining the overall
profitability of a trading system. Generally I would like to see 50% or
more - however it really doesn't matter all that much to me. The percentage
of winners is totally dependent upon the traders' psychological makeup.
Maximum Number of Consecutive Winning and Loosing Trades
Calculation: Determine the maximum number of consecutive winning and
loosing trades.
Average of Maximum Number of Consecutive Winning and Loosing Trades
Calculation: Average the maximum number of consecutive winning trades.
Average the maximum number of consecutive loosing trades.
These two numbers will begin to tell us what we could expect in actual
trading and will be one of the first indications that the trading logic has
gone astray when trading in real time. They are also totally dependent upon
the psychological makeup of the trader.
A word of warning.
The challenge of creating a trading system for an experienced trader is
that he is attempting to create a mechanical version of himself. Computers
are incredibly dumb machines and cannot change their "programming" on the
fly. They are very systematic and they are not discretionary. This is their
weakness and their strength. Most experienced traders are to a certain
degree discretionary in their day-to-day execution of trades.
Because computers are very systematic they will always execute the code in
the same manner with the same results provided the inputs are the same.
Should the inputs change then the output will change. The goal of every
trading program is to execute the same buy regardless of when the data
stream was started. In other words if we are using 3-minute historical data
that starts on 4/1/01 and ends on 4/1/02, and our logic only needs 30 days
of 3-minute data. If our system generates a buy on 10/1/01 1:30pm, and then
exits the trade at 10/1/01 2:15pm our goal is for the buy to be generated
for 10/1/02 1:30pm regardless if the data stream being used starts on
4/1/01, or 8/1/01.
All too often this is not case, the date and time the data stream begins
will prevent the trade on 10/1/01 at 1:30 from being triggered. The goal is
that the trade consistently be triggered.
Another problem is that using historical data to create a trading system
will in actuality create a system that has been "curve fitted" to some
extent - regardless if optimization studies were performed on the
variables. This is because the system creator has the vision of 20-20
hindsight. Curve fitting becomes apparent data from a different time period
is used.
This is why the adage you read everywhere "past performance is not
indicative of future performance" - because it is the truth. This is true
of a computer based trading system or an individual trader!
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