List of parameters to evaluate a trading system

Below are the parameters used to evaluate the performance. Each parameter can tell us something different: Profitability, risk, trade frequency, duration, reliability, win rate or any other measurable factor. It is important for you to know which ratios are best and which statistics make sense for you.

Here are some ratios and statistics that I usually analyze when evaluating the results of a trading system:

Net profit:

This is quite understandable. This parameter represents the profit of the system, which can be expressed as a percentage of the initial capital.

➡️ In an ideal environment, the higher the potential for a trading strategy to generate net profits, the better for the trader. However, we must analyze this parameter in detail:

  • Is it stable over time or are there negative periods?
  • How many profitable trades does the trading system generate?
  • Are only a few trades profitable and the rest just losses?
  • How many losses must the system take to make this profit?

Annual gross profit:

CAR = 100% * ((total year-end capital / total initial capital) ^ (365 / trading day with strategy) - 1) (^ is exponent)

➡️ The bigger the gross profit, the better the strategy.

Risk Level (As a percentage of the time a trader is exposed to the market)

It is the percentage of the time that the trader is exposed in the market.

Exposure = (Time we hold the order / Total trading time in 1 year) * 100

Example: A trading system with always open positions, buy & hold style, would have 100% exposure.

➡️ The system makes us enter orders more, the longer the system, the more risky this system is.

Drawdown ratio

The drawdown tells us how much we are losing since the last peak on the capital curve.

Maximum drawdown is the maximum distance between the top and bottom on the capital curve. In other words, it is the distance between the highest high and the next low.

➡️ Systems with a large drawdown rate and systems with more risk.

Recovery factor

It is the result of dividing the net profit by the maximum drawdown of the system.

Recovery Factor = (Maximum Net Profit / Loss)

➡️ It measures the recovery rate of the system after capital declines. Obviously the higher this ratio, the better the system we are using.

Profit coefficient

It is an important performance indicator of a trading system and one of its biggest advantages is its simplicity.

The profit multiplier is the result of dividing the amount that the winning trades earn by the amount lost on the losing trades.

Profit Factor = profit on profitable trades / loss on losing trades

➡️ A value-for-use system is a system with a profit coefficient that must be greater than 1, if it is less than that means the system is not profitable.

Transaction frequency

How many trades were made during the analyzed period?

When comparing the performance of different trading systems, it is important to take into account the frequency with which trades are executed.

➡️ If 2 systems have good profit coefficient, good net profit. You should choose a system with a lower frequency of transactions, the fewer transactions, the less tired you will be.

Win rate

This coefficient measures the number of winning trades out of the total number of trades executed.

This ratio indicates the reliability of the system, and also allows us to see how comfortable it is to use. Psychologically, it is very difficult for a trading system with a low win rate to outperform a system with a high win rate, even if the profit per trade is very high.

Number of consecutive losses

➡️ It's good to know you can tell how many trades the system suffered the longest losing streak in a row. On the one hand, this ratio can have a big impact on a trader's psyche. On the other hand, knowing the number of consecutive losses we are likely to face will help us to better plan money management.

Mathematical expectations

Having a positive mathematical expectation is an indispensable condition that any minimally reliable system must meet.

The formula for calculating the mathematical expectation of the trading system is:

Mathematical Expectation = (Probability of Winning X Average Profit) - (Probability of Losing X Average Loss)

➡️ To make money with a trading system, it is not necessary to win on all trades. It's a combination of how many times we win or lose and how much we make per trade.

Attention: You need to have a positive mathematical expectation to be able to win in the long term with your trading system, that is always the basic condition. However, when you reinvest your profits, the final amount of profit will depend on the geometric mean.

Sharpe ratio

The Sharpe ratio measures the return on the dispersion of results, or the rate of return earned per unit of risk when investing in an asset.

It is calculated as the annual return minus the risk-free return (bonds or bank deposits) and this result is divided by the standard deviation of the investment.

Formula for calculating Sharpe ratio:

Sharpe = (Annual Return – Risk Free Return)/Standard Deviation of the Investment

➡️ The higher the Sharpe ratio, the better the trading system

CZK rate

Like the Sharpe ratio, the K ratio also assesses risk-based profitability, but it relies on a different angle because the K ratio takes into account the order in which results are produced.

The K-ratio evaluates the performance of a trading strategy based on the stability of the equity curve. The higher the K-factor, the higher the profitability of the system and the lower the bias of the results.

In the K-ratio, performance is expressed as the slope of the linear regression and risk is expressed as the standard error of the regression.

SQN - System Quality

SQN is a performance metric developed by Van Tharp.

SQN is based on the relationship between mathematical expectation (we explained this concept above) and standard deviation. All are measured in multiples of R.

But what does a multiple of R mean? Here is a simple example of a multiple of R: We open a position at $100, with a stop loss at $80 and close the trade at $150. The multiple of R in this case would be 2.5 (50/20).

Ratio formula SQN = number of transactions * Expectations measured in R Standard deviation of multiples of R

The higher the system quality factor, the better the system's profitability.

MAE – Maximum temporary loss

The term MAE refers to the maximum loss you incur while trading until you close the order

MAE = (entry price – highest or lowest price of the day) / entry price giá

Let's take a look at the following example:

➡️ MAE is used to measure the risk and capital required to trade.

MFE - Highest temporary profit lợi
MFE, or Maximum Temporary Profit, is the maximum profit we get while trading until closing.

The MFE is also used to measure the risk and capital required to trade.

Capital curve of the trading system

In addition to checking the indicators and ratios, don't forget to analyze the capital curve of the system.

By representing the results as a chart, it is much easier to see your trades grow over time and has a better perspective.

Capital curve example:

Before choosing a trading system, you must back-test and calculate the above parameters and ask the questions: Will you make a large profit with the risk of a significant loss of capital? Do you like a high win rate, even if the risk is high? Do you want to make big profits on few trades or on many trades per year?