Most traders begin trading based on the recent past performance having been attracted by the winning equity curves. This is one of the biggest auto trading mistakes done by traders.
You can evaluate a trading strategy better by understanding the following concepts:
- Backtest Results
- Backtest vs Live Results
- Basic Performance Metrics
- Diversification and Correlation
Are back test Results Reliable?
While live trading on real money account is one of the most reliable form of strategy analysis, backtest results are equally important. It is quite easy for a strategy to be successful in real trading for three months, six months or maybe even one or two years. This leads to setting trade sizes at risk levels which will be harmful to the account when an unexpected drawdown occurs. But there is no guarantee or information about the actual drawdown the strategy could potentially see in future trading – drawdowns which may just be a normal part of the strategy.
Backtest should ideally be conducted on high quality tick data with spreads similar to real trading conditions.
However, it must be noted that strategy developers can manipulate backtests by tweaking the strategy to avoid some serious losses and drawdown periods. Even conducting the backtests on your own system will not be able to detect a dishonest, manipulated or curve fitted strategy.
Back tests serve a good purpose and it should be used as a reference to set risk levels and know what kind of drawdowns should be treated as normal part of the trading strategy.
The Litmus Test : Back Tests vs Live Results
There is only one way to verify if the backtest results of a particular strategy is valid – Comparing the live trading results with the backtest result of the same period.
For example, let us assume that a strategy has backtest results for the period between 2010 to 2017 and live trading results from 2018. In this case, the strategy should be backtested for the period of 2018 on the same data source used for conducting the longer period tests. The result obtained from backtest should be compared with live trading.
If the results are similar, the longer backtest can be considered valid for further evaluation of strategy.
If the live trading and backtest results are different, whatever the reason may be, the strategy was most likely curve-fitted or manipulated to produce attractive results during the backtested period. Any strategy can be profitable over shorter timeframes and are bound to fail when price action changes. Therefore it is recommended to consider only strategies that have backtest results of at least 3 years or more. Honest and verifiable backtests ensure the ability of the strategy to survive through price action cycles seen previously.
Performance Metrics of a Trading Strategy
Knowing about the basic performance metrics is a crucial step in evaluating any trading strategy. Since automated strategy is a black box developed by someone else, traders using it need to evaluate its potential performance based on its past results.
This is similar to buying a car – you need to know its basics like top speed, acceleration, fuel consumption, carrying capacity, etc. You do not need to be an auto engineer to drive, but knowing the basics will help you understand if the car will serve your purpose and meet your expectations.
First verify that the long term backtest results are valid and satisfactory. Always select backtests made using fixed lot size to avoid effect of compounding. Use pips for analysis as it is more accurate than currency values which vary from time to time.
Make notes of the following data:
- Number of trades per month
- Average Gain and Average Loss (in pips)
- Risk:Reward and Success Rate
- Max Gain and Max Loss (in pips)
- Maximum drawdown (in pips)
Set your gain and loss expectations of trading the strategy based on the above metrics.
Understanding Trading Strategy Drawdowns
Drawdowns are part of any business and an integral part of trading. It is also the most overlooked and misunderstood concepts. Most traders find it difficult to understand and accept that such losses cannot be avoided.
In order to profitably trade a strategy, it is important to know before hand the drawdown involved.
When choosing any automated strategy, analyse the maximum drawdowns seen in past three to ten years. Always set your trading risk based on the assumption that maximum drawdown level may happen at any time and be mentally prepared to ride out such losing periods. Stopping a good strategy during its normal drawdown period is one of the most common mistakes made by traders.
Forex Live Trading Performance :
A Case Study
In this case study, the strategy has the following long term trading metrics :
Win rate : 60%, Risk : Reward = 1:1
Average Gains = 30 pips, Average Loss = 30 pips
Max Drawdown = 600 pips
Let us assume that three traders begin trading the above strategy at different dates. The results each trader sees on their accounts is summarized below:
Trader A : Starts with a winning streak, rides over the losing period and goes on to make further gains over next few months.
Trader B : Started trading based on recent gains, but starts off on a losing streak. Seeing the losing performance on his account, the trader stops the strategy during its drawdown which was about 300 pips.
Trader C : Starts trading on a winning streak with performance slightly above long term averages and should know that losing phases are normal and are not predictable. In this case study, Trader B is unprofitable since the strategy’s drawdown was not taken into account. It is understandable that traders want to be on a winning spree and avoid any losing streaks. Experienced traders know that this is futile and will lead to larger loses in the long run.