Key ratios that let you know the health of your trading performance
While the art of trading is itself a difficult skill to master, determining success in the industry is a much easier task.
Simply put, if you want to know how efficient you are as a trader, look no further than the statistics of your trading performance.
While it’s not a guaranteed indicator of future success, by reviewing the efficacy of past trades, through the use of various formulas, you can have a good idea of where your future trades will fall.
In this article, we’ll cover the main recipes for determining future outcomes, as well as explain what these statistics can tell you about trading, what else they’re good for, and why you should be more aware of the value of their output.
The Basics: Profit Factor
This first measurement is a simple equation that takes all of your monetary profit and divides it by your monetary loss. Simply put, all the winners divided by all the losers.
This easy division will result in a value above 1 or below 1. If you have a profit ratio below 1, let’s say 0.3, it means you have a negative probability or expectancy on your whole portfolio earning.
If you have above a 1, let’s say a 2.5, then you have a positive earning probability. This means that on every trade you enter, the probability for you to earn is the value of the profit factor. It’s generally agreed upon that if you have a profit factor above 2.0, that you have a very stable and efficient trading performance.
This ratio can also tell us the efficiency of your trading expectancy. You can also use the same ratio to calculate with pips or points but the profit factor is usually done just with the monetary worth. Money management is the big considerable in the value of the ratio.
This is a very basic stat we’ve titled it the first one because it’s perhaps the most simple yet effective indicator of a trader’s success. Are you making enough money or not?
This easy to calculate formula will tell you right off the bat whether your trading system and plan are bringing in enough revenue versus few enough losses to be consistently successful.
The Drawdown – Relative and Absolute
We covered the drawdown characteristics in quite a bit of depth recently but it’s worth mentioning again in the context of ratios which are incredibly helpful when judging the viability of future market moves.
Drawdown is a measurement of any performance and how much loss it can absorb before it starts to eat into profits.
A drawdown is related to a single position where you enter the position and the price may go against you and put you in a relative loss before going up once again.
It is also used to be measured on a whole portfolio where you take the winners and the losers together to determine what was the highest sequence of accumulating losses in the portfolio.
The Relative Drawdown
The determination of this first type of drawdown begins where the pivot point is at the highest peak of value of the portfolio. For example, if you have a 50k account and you make it up to 55k but then fall down to 40k, then the drawdown is counted from the 55k to the 40k.
The trading behavior is capable of making that consecutive loss from 55k to 40k which is greater than a 20% change.
The Absolute Drawdown
For the absolute drawdown, the pivot point would instead be from 50k to 40k which is only a 20% change. This is the main difference between the two types.
Here’s another example: We have the same 50k and the trader brings it up to 60k. That’s a 20% gain. But then, from the 60k account, the portfolio went all the way back down to 50k. In terms of absolute drawdown, it’s 50k divided by 50k. That’s 0 in drawdown. Apparently no damage is done.
Being aware of the drawdown type depends whether you’re an investor or a trader. As a trader, you need to be more aware of the maximum risk your strategy will allow. If you’re showing numbers to an investor, they would only be concerned on the maximum risk only in regards to the money they invested.
Average Win/Average Loss
The concept will give you a brief insight into how much you tend to earn when you’re earning, how much you tend to stop your trades while winning and how much you tend to stop your trades while losing.
It’s important because at different stages of trading levels, one of the sicknesses of amateur traders is that they are taking very big losses in relation to very low winners.
If you put together the two values (average winners in money or pips with the average losses), you should see that you might be taking average wins which are bigger or lower than average loss. This tells you whether you need to tweak anything in order to have the average losses lower than the average winners.
Take all the losing trades, sum them together and divide them by the count of the losing trades. Same thing should be done for the winning trades. Sum up the value of the return of winning trades and divide them by the count of all the trades.
The end goal is to have an average win that is greater than an average loss. If you have this, you’re on the right path towards being an efficient trader.
Similar to the first ratio we outlined in this article, the win/loss ratio is fundamental and straightforward as a measure of your success as a trader.
The win/loss ratio is the total number of winning trades against the total number of losing trades.
Wins divided by losses = win/loss ratio.
The one caveat to the formula laid out above is that it’s not as cut and dry as it might appear on the surface. Common sense dictates that the average profit per trade be greater than the average loss per trade.
While this would seem to be the sensible standard by which to apply the formula, the truth is, there are many ways to be successful and sustained as a trader.
This means that you don’t have to have a win/loss rate of 3:1 or 2:1 to be considered a success in the field of trading.
Trading is a deeply personal business which relies on the individual strengths of it’s traders to succeed. So, if you don’t hit such a ratio, it doesn’t mean you’re bad or good.
In the end of the day, if you’re bringing in consistent profits and can maintain and sustain yourself with your existing trading plan and strategy, you are likely a competent and capable trader.
The Sharpe Ratio
Finally, in the list of ratios that should always be on your mind as a career trader, the Sharpe ratio takes its place.
The Sharpe ratio describes how much excess return you receive for the extra volatility you endure for holding a risky asset.
In order to calculate this ratio, you take the average rate of return on your investments minus the best available rate of return, divided by the average rate of return.
Visualized, it looks like this:
Measured returns can be calculated in any way that you normally find them distributed. If you’re only holding on to prices for a day, calculate it daily. If you hold on to prices for weeks at a time, calculate the returns weekly.
However, if there are changes from how long you hold assets, let’s say you hold some for hours and others for days, the ratio will be skewed and not necessarily an accurate measurement of your trading performance.
If you have consistency in the timeframe in which you enter and exit the market and can accurately input measured assets, this ratio is incredibly helpful when it comes to putting together your risk management strategy as part of your overall trading strategy.