How To Evaluate A Trading System
Developing a trading system is not that tough. Any individual can build their own profitable trading system by just having some elementary knowledge of computer and technical analysis.
But the question arrives here is whether that developed system will last long and what will make that system better than other thousands of other trading systems that exist out there.
To solve these problems to some point, there are some important parameters that the trader or developer should know to look into to evaluate a trading system.
There are many books, websites, and magazines that briefly explain how to evaluate trading systems. There are also many online and offline courses available out there that teach how to evaluate trading systems along with teaching all about the stock market.
The Thought Tree (T3) is one of the best stock market institutes which offers the best stock market course. In this course, they teach everything needed for the stock market, including how to evaluate a trading system.
Tips To Evaluate A Trading System
We can define a Drawdown as how much trading or investment is down from the level of the peak before it recovers back to the level of the peak.
It is a measure of downside volatility. Drawdowns are usually expressed in percentage (%), which shows the largest drop from peak to trough on a stock chart.
For example, if a trader’s capital is 1000, and the backtesting shows that the trader’s capital can drop up to 900 due to losses realized, then the trader’s maximum Drawdown is 10 or 10%.
We can calculate the maximum Drawdown as follows:
Maximum Drawdown = Peak Capital – Lowest capital
And we can also calculate the maximum Drawdown percentage as follows:
Maximum Drawdown Percentage (%) = (Peak Capital – Lowest Capital)/Peak Capital * 100
2. Average Risk Reward Ratio
The average Risk Reward Ratio is the ratio of average profit and average loss based on the report of backtesting.
Let’s take an example. If the average profit the system encountered over some time is 1000, and the average loss is 500, then the risk ratio is 1000:500 or 2:1.
The risk-reward ratio correlates with the system’s success rate. With a risk-to-reward ratio of 1:2 or 0.5, getting 33% of your trades will give you a profit.
So, even if 67% of your trades end in losses, your net portfolio will still be green if your risk/reward ratio is 1:2. If the risk-reward ratio can be lowered further, the break-even success rate will also be lowered.
So, here the fact is that the lower the risk-reward ratio, the better the system will.
We can calculate the Average Risk Reward ratio by the following formula:
Average Risk Reward Ratio = Average Loss / Average Profit
3. Maximum Losing Streak
Maximum Losing Streak is the largest possible loss in a row. This parameter has nothing to do with the total performance of the system but is an important physiological factor that determines whether you can trade based on this system.
A trader usually doesn’t like systems where he has less than 5 maximum losing streaks.
4. Sharpe Ratio
Sharpe ratio is defined as a measure of the risk-adjusted return of a financial portfolio. Sharpe Ratio measures the average risk-adjusted return and compares systems with different risk profiles.
Calculation of the Sharpe Ratio is done by taking the difference between the total returns and the return of risk-free investment. Then this difference is divided by the standard deviation.
5. Periodic Evaluations
In a perfect world, making changes would automatically improve trading results. But we live in an imperfect world, and we trade in imperfect markets. The changes you apply may or may not produce the desired results.
The only way to know for sure is to track performance in a targeted and objective manner under updated trading terms. If all goes well, you should notice a big difference between past and current futures trading results.
Again, we underscore the importance of collecting a sufficiently sized sample, as too small a sample size can lead to misinterpretation of the overall impact of a change. Whether the overall results are good or not, be patient and give the system time to prove itself.
6. Iterating Until a Trader finds the most viable product
As a trader, you may prefer to think like a designer rather than a strategic planner. After all, markets change, and systems may require periodic “updates, ” similar to adjustments and overhauls.
Remember that successful traders can adapt to different market conditions. Additionally, you can assess whether changes in market conditions require changes in strategy, systems, style, or approach.
Being able to both assess the need for change and adapt accordingly is an ability that can only be achieved by doing so. It means failing repeatedly and finally succeeding.
These are some parameters that can help to evaluate a trading system. To improve themselves as a trader he or they should take more proper knowledge of everything they are doing.