When assessing the performance of a trading system, one of the first statistics that gives you a good indication of tradability is the win-to-loss ratio. Quite simply, this is the ratio of the average winning trades taken against the average losing trades taken. If this ratio indicates you are, on average, winning more than you are losing, you are on the right track.
But don’t get caught up in this statistic on its own, because it doesn’t tell the whole story. It doesn’t consider the size of your winning trades versus the size of your losing trades. Remember the Turtles? Their win-to-loss ratio was 40:60, but they were still hugely profitable.
Average wins and losses
In addition to the win-to-loss ratio, you will want to make sure that the average value of your winning trades is greater than the average value of your losing ones. Say your back testing consisted of 200 trades. If 150 are losing trades and only 50 are winning trades, obviously your win-to-loss ratio is 25:75. But that on its own isn’t enough to determine if a system is good or bad.
Understand that, if the average of your wins were, for example, $2000 and the average of your losses were $500, you are still coming out on top ((50×2000)-(150×500)=$25,000).
A trading system’s expectancy is perhaps one of the most powerful statistics you can have because it is a way of quantifying the performance of a system that is independent of the size of the trading float.
In short, it produces the expected dollar return for each dollar risked by the trading system. This is different to the reward-to-risk ratio and average wins to losses that we described above, in that it defines a return in dollar terms for every dollar that you risk. If your system has an expectancy of +0.75, on average, you would expect to make 0.75 times the amount you risked in the trade. If you risk $1, then you would expect to make, on average, $0.75 for every trade you take.
Maximum consecutive losses
Look back through your testing results to see, statistically, how many losses in a row your system sustained while still being profitable. This is important to know upfront, since this statistic will give you confidence during those low times when it feels like you should throw in the towel.
For example, imagine you have been hit with five or six losses in a row. Without knowing your maximum consecutive losses, you might think your system isn’t working. This is where most naive traders go wrong. The truth be known, based on the historical data, your system may have actually sustained 10 losses and still been profitable.
The maximum drawdown is the worst period of ‘peak to valley’ performance of your system, regardless of whether or not the drawdown consisted of consecutive months of negative performance.
This statistic is automatically calculated, so it’s just a matter of asking yourself: am I comfortable with that size loss? If not, you will need to do more system tweaking to get it to a level that you can live with.
Again, it all comes back to the risk-to-reward ratio. Typically the more risk you take, the greater the reward. I have traded a system in the past that returned 140% p.a. Now that sounds great, but that particular system had a maximum drawdown of 80%. Could you trade a system where it’s likely you’d lose 80% of all your capital at least once while trading it? Could you stomach that?
It’s important you trade a system you’re comfortable with.
Number of trades
Then there’s the number of trades a system gives over the course of a year. I find this an invaluable, yet rarely talked about, statistic.
Your trading system should not give too many or too few trades. The number of trades that a trading system gives should be approximately the same as that which can realistically be taken.
The two sides of the coin are equally dangerous. If a system gives too many trades, you will be forced to choose between signals, therefore adding ambiguity to the system. With ambiguity comes human discretion and this often has a detrimental effect on the performance of the trading system.
On the other hand, if a system gives too few trades, your trading capital will not be fully utilised and you may not be taking full advantage of the available trading opportunities.
So how do you calculate the optimal number of trades for a trading system?
This is done with the calculation called ‘opportunity’. Opportunity helps determine your optimal opportunity for a trading system.
Profitability is simply the return on investment over a yearly term.
Let’s be blunt. We’re all in this to make money. At the end of the day, profitability really is the most important metric by which to measure your trade system. But, while it’s important, it needs to be balanced with the other six measures I’ve just discussed.