5 Ways to Measure Performance

10/21/2013 6:00 am EST

Focus: TRADING

Performance metrics help traders determine how a system is performing, but it’s important that they also look at the big picture, says Jean Folger of PowerZoneTrading.com.

There are a hundreds of different performance metrics, or statistics, which can be used to evaluate a trading plan. Traders often develop a preference for those metrics that are most valuable based on their particular trading style or business goals. Here, we look at several performance metrics that can be important for assessing a variety of different trading plans.

Maximum Drawdown
Maximum drawdown refers to the “worst case scenario” for a trading period. This measures the greatest difference, or loss, from a previous equity peak. This statistic can help measure the amount of risk and establish if a strategy is possible given the size of the trading account. In general, this number should be as small as possible, and trading plans that require large maximum drawdowns should be avoided.

As a basic rule, a trader should begin analysis of a trading plan by determining how much he or she can afford to risk. If the maximum drawdown for a trading plan exceeds this amount, the trader may not need to look any farther; the plan must be revised before it can advance to the next level. While this performance metric often appears at the bottom of performance reports in many software packages, it is among the most valuable. It is recommended that traders begin their analysis by looking at the maximum drawdown, as this determines the feasibility of a trading plan.

Total Net Profit
The total net profit represents the bottom line profit or loss for a trading plan over a specified trading period. This statistic is calculated by subtracting the gross loss of all losing trades (including commission) from the gross profit of all winning trades. While many traders use total net profit as the primary measure of trading performance, this statistic by itself can be deceptive.

Just knowing how much money a trading plan would have made during a trading period does not provide enough information to measure whether the plan is performing up to its historical standards, or if it is efficient. Since it is assumed that trading plans will have a positive expectancy, the more time a trading plan is in the market, the more it should theoretically make. By comparing the same plan during different trading periods, therefore, traders could expect significantly different total net profit results. In addition, this metric does not allow us to normalize the results of a trading plan based on the amount of risk that is incurred.

Let’s face it, we all want to know how much money a trading plan could have made…our business depends on this type of projection. We must be careful, however, not to get blinded by this number, and we must continue to look at the overall statistics for a trading plan. Total net profit alone does not allow traders to adequately compare or track the performance of a trading plan.

NEXT PAGE: 3 More Key Metrics

|pagebreak|

Profit Factor
The profit factor is defined as the gross profit divided by the gross loss (including commission) for the entire trading period. This performance metric relates the amount of profit per unit of risk, with values greater than one showing a profitable trading plan.

In theory, this number should be as high as possible. In reality, extremely high profit factors rarely correlate to actual trading performance. Most successful trading plans may have anywhere between a 1.5 and 5.0 profit factor. One method of comparing profit factors is by looking for consistency over time, regardless of the trading period.

Percent Profitable
The percent profitable is also known as the probability of winning. This statistic is calculated by dividing the number of winning trades by the total number of trades for a given trading period. The percentage of profitable trades depends entirely on the type of strategy employed in a trading plan.

Typically, trading plans will have between a 40 and 60 percentage of winning trades. Trend following strategies tend to have lower values, while trading plans using counter trend or shorter-term styles of trading tend to be higher. In addition, trading plans that rely on values greater than 80% are rarely reliable in live trading. Traders do not necessarily need a high percentage of profitable trades to create a successful trading plan. A more important goal of using this metric is to find a consistent percent profitable during each level of development, and in live trading.

Average Trade Net Profit
The average trade net profit is the expectancy of a trading plan. This metric represents the average amount of money that was won or lost per trade, and is calculated by dividing the total net profit by the total number of trades. This metric provides a useful indication about the future performance of a trading plan. This calculation is significantly affected by the position size, since larger position sizes will magnify the average winning and losing trade amounts.

For this reason, it is recommended to initially test a trading plan using a constant, minimal position size. This will allow a more accurate comparison that can be used to gauge the efficiency of the plan. In other words, traders should avoid increasing position size to improve this statistic.

Another factor that should be taken into account is how close this average relates to the biggest trades. Occasionally, historical modeling results may be skewed by a single trade that creates a profit (or loss) many times greater than a typical trade. This type of trade, known as an outlier, may create unrealistic results by over-inflating the average trade net profit. In this case, it may be best to remove the outlier, especially if the success of the trading plan is based on this single trade. Trading plans that rely on one or two abnormally large trades over a trading period are often closer to gambling that realistic trading.

Conclusion
Performance metrics help traders determine how a system is performing, but it’s important for traders to look at the big picture: focusing on one metric (such as total net profit) can be deceptive. Many metrics are most meaningful when compared with other metrics. For example, average trade net profit can be compared with percent profitable to get a better idea of how much the system wins how often. The five metrics listed here serve only as an introduction to the types of metrics traders should look at when analyzing systems: the metrics you choose will depend on your level of expertise, trading style, and preference.

By Jean Folger of PowerZoneTrading.com

Related Articles on TRADING