In the last article on strategy evaluation, we talked about some ratios you can use to get a better handle on your trading and how it is performing.
You don’t have to use each ratio separately, but it’s also possible to combine them and play them off each other, as you do with indicators in your trading.
One of the more useful things that ratio analysis of your trading can uncover is counterintuitive results; when things you expect to happen aren’t happening.
This is why it’s important to go through the “control” part of your trading strategy, and reviewing performance. You might be doing everything right, but the result is not what you expected
Following a good strategy doesn’t always lead to a good result.
Let’s consider a simple scenario: you find a successful trading strategy. You see your account balance going up, clearly, the strategy is working, and you start trading that strategy and using that combination of indicators as much as you can.
It works, right? So why, after a while, do you notice you aren’t making as much money, or worse, your account balance is starting to go down?
This is one of the counterintuitive scenarios that can happen when trading, that you’ll need to use your evaluation ratios to figure out – or, ideally, prevent from happening in the first place.
It doesn’t seem logical, so it won’t be something you’re going to expect to happen, unless you are keeping track of your trading and your trading results, and then reviewing them with some statistical analysis.
How does this happen?
Several things could be going on, and there are different diagnostic tools we can use to find out for sure.
First, we need to know that it’s connected to trading frequency, and not just a fluke of the market. So, you have to be keeping a record of your trading frequency, and a record of your trading profitability; then notice that as your frequency goes up, your profitability isn’t going up correspondingly.
If you cut back on your trading frequency, and you notice that the situation resolves, you know might want to look at why increased frequency is messing with your trading mojo.
One of the simpler explanations for this phenomenon is that when you were trading less frequently, you were picking the best potential trades, i.e. the ones most likely to result in a positive outcome. So, as you increased the number of trades, you must have had to take on some that were more risky, and in the long run, more of those must-have not worked out. You can see this if while your frequency went up, your profit loss ratio when down, for example.
A variant of that situation might be that in order to take on more trades, you traded longer, moving out of a certain window where the strategy was optimal. For example, if it is a strategy that relies on market volatility, you might have had great results in the LONG time period, but the strategy’s effectiveness tapers off as the volatility goes down going into the later US session. This is why keeping track not just of your trades, but of the time you were trading is useful.
Calculate your way to profits
You wouldn’t be able to identify these problems if you didn’t apply cold, hard math to the issue – a more impetuous trader might have opted to increase trading even more, because he knows the strategy works, he just needs to get more pips to make money. That would compound the problem.
You can preemptively use this technique while backtesting, for example, to determine what the optimal trading frequency for your strategy is. It might be that as you increase your frequency, your profitability goes up because you are underutilizing your strategy.
This seems intuitive; but at a certain point, the profitability might turn around, and to find the exact point, you need to apply the ratios we discussed.