Performance of a trading strategy is measured with a set of parameters. For example, if you are trading in equity then your returns are compared against the benchmark index. Consistency of returns of the strategy also proves to be a significant factor. Did the strategy perform well when the index suffered? Strategy would be deemed successful even if it has incurred loss but has lost less than the index. So in this article we will look at such performance metrics that gives an insight into the anatomy of a trading strategy. This post is the summary of the webinar on Performance Evaluation and Money management held by QuantInsti.
When asked what the stock market will do, Benjamin Graham said, “It will fluctuate”. There is no sweeping method by which one can predict the exact movement of the market direction. Forecasting methods involving various techniques always come with an element of risk. The higher returns from the market are attributed to the higher risks investors carry. Most of the performance metrics revolve around the risk factor. Let us have a look at some of them.
Performance Metrics Revolving Around Risk
It is a measure of the excess return per unit standard deviation in an investment asset. It provides useful information regarding the return of an asset for a given risk.
Limitations: It is based on historical data thus assuming future would be a repetition of past. It does not give a clear picture of tail risk. It does not account transaction costs and maximum drawdowns.
Modified version of Sharpe ratio where standard deviation of negative returns are considered. It is the portfolio returns minus risk free returns divided by downside(negative) standard deviation.
It is a measure of drop from the peak to bottom value of the cumulative returns.
It is the ratio of return (typically annually compounded) to the maximum drawdown.
It is the ratio of annually compounded return to the difference between average maximum drawdown and 10%.
Up capture ratio
A statistical measure that measures fund’s return with respect to the benchmark’s return. A ratio greater than 100 indicates that the fund has outperformed the index.
Down capture ratio
A statistical measure that measures fund’s return with respect to the benchmark’s return. A ratio less than 100 indicates that the fund has outperformed the index.
Up percentage ratio (Performance ratio)
It is a measure of number of periods that a fund outperformed the benchmark when the benchmark was up divided the number of periods that the benchmark was up. Higher the ratio better is the performance of the fund.
Down percentage ratio (Performance ratio)
It is a measure of number of periods that a fund outperformed the benchmark when the benchmark was down divided the number of periods that the benchmark was down. Smaller the value better the performance.
Money Management Techniques
Having discussed various performance metrics, let us have a look at the money management techniques. What portion of your wealth should you devout towards trading? How do you decide on the amount you should invest? In laymen terms, don’t invest more than what would make you sleepless. Some of the metrics discussed above could be considered. Maximum drawdown could be a deciding factor to limit your portfolio losses to a certain limit. To see how ugly math can be, consider a simple example. Suppose you have invested 100 rupees and unfortunately you lost 60% due to extreme market movement. Not that your worth is 40 rupees, to bring it back to your initial value you have to make a gain of 250%!
Martingale method is another criterion to position the trade size. This involves increasing your bets after every loss and decreasing it after every loss. Antimartingale method works on the opposite logic. A famous criterion known as Kelly’s criterion or Kelly’s formula is used to determine the optimal size of the bets. It is focused on the long term capital growth. It takes into account winning probability as well as average wins and average losses.
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