Last Updated on July 29, 2022 by Oddmund Groette
Trading system and strategy performance metrics are important parameters to evaluate the quality of your trading strategy. Just looking at the end result, the CAGR or the annual returns, might be very misleading. If you’re a short-term trader we are pretty confident in saying that most traders would abandon a strategy if the drawdowns are too big no matter how high returns. This is why you need to look at strategy and system performance metrics. You need to measure your trading performance.
This article looks at several trading strategy and system performance metrics: the equity curve, max drawdown, the win ratio, the Sharpe Ratio, the profit factor, the CAR/MDD, the RAR/MDD, and the Ulcer Index. There are many more metrics, but we believe these should offer a very good background on where to look when you develop trading strategies and systems.
Trading strategy and system performance metrics don’t need to be complex
Trading strategy and system performance metrics are not complex. As a matter of fact, you get a very long way by using common sense and knowing your own limits. As we have explained many times, street smarts beat book smarts in trading!
Nevertheless, it might pay off to know a little about the different performance metrics that most trading software displays after you run a backtest.
As you can see, there is an abundance of metrics and numbers. Luckily, you don’t need to know them all. The most important in the report is, in our opinion, the max drawdown. Why? Because risk is mainly the risk of losing money, either permanent or temporary:
What is risk
In this article, we define risk as downside volatility. It’s certainly not a perfect proxy for risk, but it makes sense because it is highly correlated to behavioral mistakes.
What are behavioral mistakes in trading? That is, for example, selling into a panic only to discover you nailed the bottom.
To better illustrate the return and risk, let’s look at the chart below:
The red line is the performance of a Swedish hedge fund, while the grey line is the MSCI World Index. Which path would you prefer to traverse – the red or the grey one?
Beginning traders and investors look at the annual returns and might pick the grey line because it has the highest returns. However, that is a little hindsight or survivorship bias. It’s easy to pick the best option when you know the result. But clearly, the red line has a much smoother traverse than the grey line. That’s why most professional traders and asset managers prefer the smoothest ride, ie. the red line.
Let’s start with our description of trading metrics:
Trading strategy and system performance metric #1: the equity curve
First of all, you don’t need much mathematical knowledge to evaluate the performance of your trading strategy. A look at the equity curve is in most cases more than enough to judge if you have a viable strategy or not. The reason is simple:
The equity curve is the visual or graphical representation of your equity over the backtested time frame. An equity curve that is sloping gradually upward is, of course, preferable to a curve that is very volatile or even random.
Here are two examples (the blue lines on the bottom is the drawdowns):
Trading strategy and system performance metric #2: max drawdown
We have written many articles about max drawdowns.
Put short, a drawdown is the difference between the latest peak in your equity/assets and the losses suffered after that peak to a through, both realized and unrealized profits. We rank this as a very important system performance metric.
The chart below shows both the equity curve and the drawdown expressed in percent. For example, in early 2020 the strategy made a new top in the equity curve, but the Covid-19 reduced your equity from 116 000 to under 98 000. The difference between those two numbers is the drawdown. You can express the drawdown in both absolute numbers and in percentages. We prefer the latter.
Most backtesting reports show you the drawdown as in the chart above.
Why is drawdown important?
Drawdown is very important in trading because it makes a huge impact on your behavior and subsequently your returns. Even if you have a strategy that returns 50% annually you might abandon it along the way if you suffer a temporary setback in the form of a drawdown. In the midst of a drawdown, you don’t know if the strategy is busted or if it’s just temporary. In practice, all strategies stop working sooner or later.
What is an acceptable drawdown? Only you can tell, but obviously, you want it as low as possible. But this is a thin line. A small drawdown makes the backtest susceptible to curve fitting or randomness or is just something waiting to “blow up” (the calm before the storm).
On the other hand, drawdowns might be the reason why strategies can last for a long time. Drawdowns shake out the weak hands.
Our experience indicates that any drawdown bigger than 20-25% makes most traders shaky and uncertain. This results in abandonment, fiddling, or curve fitting. Thus, 25% can serve as a heuristic for max drawdown.
Trading strategy and system performance metric #3: Win ratio
One of the first risk or performance metrics you should look at is the win ratio. The win ratio is rarely mentioned as a proper performance metric, but this is probably because most writers don’t trade themselves.
Why is the win ratio an important performance metric?
Let’s first explain what the win ratio is: The win ratio is the winning trades divided by the losing trades.
A high win ratio is important because it reduces behavioral mistakes and the risk of ruin:
- A low win ratio increases the probability of having many consecutive losers. Are you willing to pull the trigger after 8 losing trades in a row? Most traders would not.
- A low win ratio increases the risk of big drawdowns.
- A low win ratio even increases the risk of ruin compared to the same size with a higher win ratio.
As you get more knowledge and experience, we are confident you’ll appreciate a high win ratio, even though your average winners might be smaller than your average losers.
Trading strategy and system performance metric #4: Sharpe Ratio
Perhaps the most used trading strategy performance metric is the Sharpe Ratio. The Sharpe Ratio was invented by William Sharpe, hence the name.
Sharpe studied performance metrics as long back as the 1960s and this is probably the first trading performance metric that was quantified. We can also mention that William Sharpe was awarded the Nobel Prize in economics in 1990, not only because of the Sharpe Ratio but for his overall contribution to finance and economics.
The Sharpe Ratio looks at the relationship between excess return to the risk-free rate per unit of risk. Practically all hedge funds use this metric to evaluate performance.
A good Sharpe Ratio is preferably above 0.75, but be careful if it’s above 1.5.
Trading strategy and system performance metric #5: the profit factor
Another widely used trading strategy and system performance metric is the profit factor. The profit factor looks at the relationship between gross profits and gross losses. For example, if your strategy has 1 000 in profits and 500 in losses, the profit factor is 2.
What is a good profit factor?
We like to use 1.75 as a threshold: anything above is reasonably good. We are not happy with extreme numbers above 4 either as it most likely signals a curve fitted test or a test that is has been lucky with the market cycles.
However, if your backtest spans a long time period you’ll rarely see any profit factors above 3 if you have a decent number of trading observations.
Keep in mind, however, that the profit factor, in reality, tells you little about the quality of the equity curve. Because of this, we add two more metrics to measure trading strategies performance:
CAR/MDD and RAR/MDD
These two system performance metrics should correlate better with the quality of the equity curve.
Trading strategy and system performance metric #6: CAR/MDD
CAR is an abbreviation for compound annual return (in percent / the same as CAGR) divided by the maximum drawdown.
For example, if the CAGR is 15% and the drawdown is 15%, the CAR/MDD ratio equals 1. You would want the ratio to be as high as possible, but realistically, this one is very hard to get above 1.
Trading strategy and system performance metric #7: RAR/MDD
RAR is an abbreviation for risk-adjusted return and MDD is maximum system drawdown.
First, we need to calculate the risk-adjusted return. This is the geometric return (annual) return in percent divided by the exposure in %. Exposure is the same as time spent in the market. If your strategy has 50 trades per year and makes 10% annual returns, this is more impressive than a strategy that returns the same but is invested 100% of the time. Time spent in the markets matter!
If the annual return is 15% and the exposure is 50%, then the risk-adjusted return is 15/0.5 = 30%
Now that we have defined the risk/adjusted return, we can calculate the RAR/MDD ratio assuming the max drawdown is 15%:
30/15 = 2
We would say that a metric better than 2 is very good.
(Keep in mind that the geometrical return is not the same as the arithmetic return. Please read our primer on the subject that explains why arithmetic and geometric averages differ in trading.)
Trading strategy and system performance metric #8: the Ulcer Index
The Ulcer Index is a relatively new indicator and was developed in the 1980s. It was primarily meant for mutual funds.
The Ulcer Index is a cousin to the standard deviation. Like many other risk parameters it looks at volatility, but only volatility on the downside, ie. max drawdown over the defined lookback period.
The reasoning is straightforward: we are only at risk if we lose money, we are not interested in risk on the upside. Most trading platforms or technical software has included the Ulcer index in their backtesting reports.
The Ulcer Index is calculated in threes steps. In this example, we use a 21-day lookback period.
First, we calculate the percentage drawdown during the period (21 bars):
((close – 21 bars max close) / 21 bars max close)
Second, we need to calculate the squared average:
((21 bars sum of percent drawdown squared) / 21 bars)
Third, we calculate the Ulcer Index:
The square root of the squared average.
Other trading strategy and system performance metrics:
The list we have provided in this article is not exhaustive, of course. There are plenty of others, like the K-ratio, Jensen Ratio, and the Treynor Ratio, for example. No matter what performance metrics you are using please make sure you understand what you are measuring. There is no right or wrong in trading and speculation, and hence you need to understand what you are measuring.
System metrics and the number of strategies – how to mitigate risk
The greatest enemy of a good plan is the dream of a perfect plan. Stick to the good plan.
The quote above was made by the late John Bogle, founder of the Vanguard group. But as a trader, not a long-term investor, you can change the quote to this:
The greatest enemy of a good trading strategy is the dream of a perfect strategy. Stick to the good trading strategy.
What do we mean by this? Many traders try to improve their trading strategies so that they end up curve fitting or fiddling with it. They dream of a strategy that has the perfect equity curve with hardly any drawdowns at all.
But even a good or worse strategy can offer good risk mitigation.
There are a number of ways to mitigate risk in trading. Frequent readers of our website will recognize our risk mitigation techniques:
You need to diversify among different strategies. If one trading strategy is far from optimal, it might supplement other strategies if you allocate a small amount of capital to it. You need to look at the sum of the components you put into your trading arsenal.
One very important aspect in that regard is correlation in trading. To minimize correlation between the strategies you need to trade different asset classes, different time frames, and different market directions (long and short). Short selling is difficult, for example, but it can serve as an incredibly useful tool as risk mitigation in a portfolio, as explained by Mark Spitznagel.
Please read our two previous articles about this subject:
Trading strategy and system performance metrics – conclusions
We have provided you with eight different trading strategy and system performance metrics, but we strongly recommend using common sense when you evaluate your backtests.
Ask yourself this: Realistically, are you able to trade the strategy and suffer the drawdowns? Even if you say no, the strategy can add valuable diversification:
You can’t discard a strategy just based on its numbers – you need to look at the contribution to a portfolio of strategies. This makes it, of course, a bit more tricky to backtest.
But the reality in trading is that the sum of many perfect strategies might perform worse than a portfolio that might have much worse performance metrics in trading. It all depends on the correlation and interaction between the strategies!