Creating a trading strategy is only the first step to trading successfully.

You must then evaluate its performance and decide if you can trust it on a live account. While so much attention gets paid to coming up with a strategy, there is surprisingly little on how to tell if the strategy is any good. Most traders take a look at the net profit, some risk-adjusted metric like the Sharpe ratio, the max drawdown, overall accuracy and, if the equity curve looks fairly smooth, it’s good to go!

However, this can be a naive approach that ignores many important aspects: Am I just overfitting the data? Exactly how risky is this strategy? Are these results statistically significant? Under what market conditions did my strategy perform poorly? If I do trade it on a demo account, how long should I wait before going live?

These are just a few of the questions you need to be asking yourself with every strategy you are considering trading live.

We’ll try to answer these questions, and more, to give ourselves more confidence in the strategies we trade live. We’ll break down the strategy’s performance into 5 categories: Profitability, Risk, Statistical Significance, Stability, and Live Performance.

This article will cover the first 2 categories, Profitability and Risk, as it pertains to an fx-based strategy.

Profitability

Profitability is the first thing most traders look at but answering the question “how profitable was my strategy?” is a surprisingly difficult question to answer. Saying it returned 20% doesn’t tell you much.

Was it 20% before or after trading costs? What type of drawdowns did you have to go through to get that 20% return? Over how long of a period did it take? If it was annualized, did you make 120% 6 years ago and nothing since?

When measuring profitability, there are a couple of important things to remember:

1. Risk-adjusted return is what matters
   • Earning a 100% return is great as long as you didn’t have a 500% drawdown to get there.
   • Here are a couple metrics to consider when measuring your risk-adjusted return:
     • Profit-to-Drawdown Ratio = Average Net Profit / Max Drawdown
       • Amount of realized profits compared to the max drawdown.
       • Ideally you would have a ratio of over 2 with any strategy you're trading live
     • RINA Index = Net Profit/(Average drawdown * percentage of time in market)
       • The RINA Index rewards strategies that spend less time in the market, decreasing the inherent market risk.
       • You want ratios over 100, but over 200 is ideal.
     • Average Max Adverse Excursion = Average of the maximum open trade drawdowns
       • While most traders only look at closed trade drawdown, it is important to consider your open trade drawdown, or the maximum loss on your position before it was closed.
2. You must at least cover trading costs
   • Especially when trading on lower timeframes, it doesn’t matter how profitable a strategy is if you can’t at least make up the cost of entering a trade.
     • The easy answer is to look at the Return Per Trade
     • RPT = Net Profit /Total Number of Trades
   • However, you need to have a good idea of what your trading costs actually are. While your broker’s “average” spread might be 2 pips, a closer inspection shows it can vary wildly. If your strategy trades a times of high volatility, your “average” spread is going to be much higher than 2 pips. You need to know what the commissions and slippage will be like when you are actually trading.
3. Effects of position sizing
   • Whether you are using fixed lot or fixed percentage position sizing is going to have a huge impact on your returns.
   • Fixed lot, or using the same position size on every trade, will lead to a more linear growth rate while fixed percentage, for example risking 2% of your capital on every trade, will exacerbate both your growth and drawdowns.
   • You need to accurately model how you will trade, including additions and subtractions in your trading account, in order to get a good idea of how profitable a strategy was.
   • As Einstein said, “Compounded interest is the 8th wonder of the world”, meaning a strategy that compounds on its returns by using fixed percentage without any withdrawals from the account will look much better than a fixed lot strategy.

Risk

Measuring your risk is a well-documented but much more difficult and misunderstood topic than profitability. Especially in light of the recent Swiss National Bank’s (SNB) actions and “Francogeddon”(or the “SNBomb” depending on your sources), the importance of understanding market risk, liquidity risk, and counterparty (broker) risk becomes all the more apparent.

Market Risk

Market risk, or the risk of losses coming from movements in market prices, is the most obvious one to traders. While the easy answer is to “always use stop losses” that is only part of the solution.

One area that is often overlooked by more active traders is the benefits of trading a diversified portfolio of strategies. Trading uncorrelated strategies is a great way to decrease your market risk and when evaluating any strategy, you must look at how it fits in with your other existing strategies.

If you had been long the EUR/CHF and short the USD/CHF you would have felt a lot better waking up to the news of the 2,000 pip move.

Liquidity Risk

Liquidity risk is much trickier and isn’t something you usually have to worry about in the most liquid market in the world but once again the recent SNB move showed why this is important as many traders were not able to exit their positions during the free fall. There isn’t a sure-fire way to guarantee you’ll be able to get out of a trade but there are a couple things you can do to decrease your risk.

• Use a true no-dealing desk STP/ECN broker
• While most brokers are switching to a no-dealing desk straight through processing (STP) or ECN model, there are still brokers that are operating as the counterparty to their traders. With an ECN broker you have access to much deeper pools of liquidity, better prices and the advantage of analyzing the depth of market (DOM) to get a better idea of when liquidity could be drying up; however, this isn’t much help with sudden market events like major bank announcements.
• Minimize your account size
• While you can’t always count on your broker reimbursing negative accounts, what isn’t deposited in your brokerage account is very difficult for the broker to collect. Unless you have a very large account and huge losses, it is unlikely the broker will come after you personally. While you must make sure you have enough in the account to avoid margin calls, you can help limit your losses to what is actually deposited with your broker.

Counterparty Risk

The importance of understanding counterparty risk, or the risk that your broker will no longer be in business when you go withdraw your money, once again become abundantly clear with the trouble of many fx brokers, including Alpari going bankrupt and FXCM’s much publicized troubles.

Hugh Kimura at TradingHeroes wrote a great article on avoiding broker risk that includes keeping a majority of your trading in a 3rd-party bank, withdrawing your trading profits, and opening accounts with multiple brokers.

One benefit of this most recent crisis is it gave us a good look into which brokers have a solid financial base and were able to withstand heavy losses. Moving forward it is a safer bet to trust your money with these brokers over others that may have had trouble.

Understanding the profitability and risk is only the first part of trusting your strategy to trade live. In the next post we’ll go over how to measure the statistical significance and stability of your strategy as well as how to know when it has fallen out of sync with the market during live trading.

How do you account for profitability, risk, and statistical significance in your trading?

Be sure to check out TRAIDE to build your next strategy using machine learning!