This video provides a simple process for evaluating trading strategies at a high level. It is intended to provide a quick and simple process to evaluate the robustness of a strategy. The intent is to use this process to determine if your strategy merits moving forward with additional resources to do a deeper evaluation or to begin forward testing. It in no way should eliminate forward testing in a simulated account. The value of this process is to prevent moving forward with a weak strategy.
Steps to Evaluating Trading Strategies
There are numerous data points that can and should be used in evaluating trading strategies. This data is easily obtained with the technology available. When evaluating trading strategies you should obtain as many of these data points as possible. The data will reveal the robustness of your strategy. Or for that matter when evaluating trading strategies from a vendor.
Step 1 the 1.2 Rule
Multiply the following:
- Profit Factor
- Percent Profitable
- Average Win/Loss Ratio
This metric should be at least 1.2. If the strategy does not meet this rule then you can stop your evaluation. This is an aggressive rule for historical data. Most if not all strategies will not achieve this rule in live testing, However, a strategy that is not at least in the ballpark will not likely be successful.
Step 2 Drawdown
You should also pay attention to the drawdown. While a strategy may look very good, if you are not able or willing to take the drawdown you probably should not trade the strategy. When factoring in the drawdown for your decision to trade a strategy, you should double the drawdown. You should be comfortable with taking twice the drawdown as seen in your back testing results.
Evaluate the drawdown against capital invested. Many times drawdowns are evaluated against back tested revenue. If a strategy is back tested over many years the largest drawdown may be a very reasonable percentage of the highest level of profit. For example if the revenue generated is $200,000 over several years and the drawdown is only 10% then the drawdown seems reasonable. However, if your recommended initial capital investment is $10,000 then your drawdown would have been twice your initial investment.
Step 3 Consistency
Consistency is your friend. Look for consistency across all parts of the results and data when evaluating a trading strategy. A good strategy will have consistency. The more consistency the better.
- Long entry versus Short entry metrics
- Number of trades
- Profit Factor
- Percent Profitable
- Win/Loss ratio
- Drawdown
- Time Periods
- Trades per period
- Profit per period
- Drawdown per period
Step 4 High Win Percentage
Typically, a high winning percent strategy will have a small profit target and a large stop loss. This type of strategy is highly sensitive to small changes in the percent wins. When evaluating trading strategies with a high percentage of wins you will need the percentage of wins, the profit target and stop loss. You can also use the average profit and the average loss.
Use the example table below and adjust the percent wins. This will demonstrate how sensitive your strategy is to a drop in the percentage of wins.
