Assess the Risk of Your Trading Strategy Before Investing

12/22/2019

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Table of Contents

Assessing your business strategy is an essential part of long-term success. Once you have found your trading strategy, you need to test it on a sample of large trades. There is no set time to properly test a strategy, it will depend on your trading style (scalping or swing trading). By having a strategy you can test it over the long term thanks to the backtesting available on most trading platforms. Otherwise, you will have to test it yourself by manually placing orders on a demo account. Testing for yourself remains the best solution. In fact, you are in real conditions and can make your strategy evolve according to your experience.

To evaluate your business strategy, you have to take into account several criteria.

Average Gain / Average Loss Ratio

This calculation allows you to determine your average risk/return rate. In other words, it tells you whether or not your average earnings expectation is greater than your risk (stop loss spread). A ratio below 1 is, of course, should be avoided. The higher your ratio, the more your strategy supports a high number of losing trades.

With a ratio of 2, for example, you only need to win 1/3 to make your trading strategy zero, as your profit expectation is twice your risk. In order to better analyze your strategy, you need to make this trade for each asset. Thus, you can remove from your strategy those assets that are less profitable or not in line with your average risk/return rate. Ideally, your ratio should be at least 1.5 and should be closer to 2.

Drawdown

The drawdown represents the maximum historical drop recorded in your trading account during a certain period of time (day, week, month, year). It is the difference between the highest and lowest in your account. The drawdown is shown as a value and/or percentage. It therefore represents the volatility of your account. The higher your drawdown, the riskier your trading strategy is. If your drawdown is too high, you need to reduce the size of your positions that are not suitable for your portfolio amount. A high drawdown does not necessarily mean that your account has been damaged. For example, you trade with $1000 and a few months later your account is at $1500. After a bad series, your account drops back to $1200. Your drawdown is therefore 20% ((1500-1200)/1500) worth 300 dollars.

This drawdown must be related to the performance of your portfolio. Here too there is a notion of profitability in relation to the risk assumed. There is no perfect drawdown; everything depends on the investor profile and risk aversion. However, the drawdown should not be greater than the performance of your portfolio. If this is the case, then change your strategy immediately.

Let’s give several examples. Your trading strategy has allowed you to achieve 50% performance over a year. During the same period, the drawdown is 25%. This means you risk 1 to win 2.

In another trading strategy you achieve only 15% performance, but the drawdown is 5%. Although the performance of this strategy is lower than the first, from a mathematical point of view it is much better. In fact, you risk 1 to win 3.

Sharpe Ratio

The Sharpe ratio measures the return on the additional risk assumed in relation to a so-called “risk-free” asset. Not to mention a risk-free asset (there is no such thing as a risk – see government bonds), it is called a benchmark. We will therefore compare the return of your strategy in relation to a benchmark by integrating the notion of additional risk. You can, for example, compare your strategy with the Dow Jones index. Having a return above the Dow Jones index does not mean that your strategy is good. In fact, the marginal risk of your trading strategy must be taken into account.

The Sharpe ratio formula is S = (R – r) / E: where R is the rate of return of the portfolio under consideration, with r being the benchmark chosen for comparison (usually the risk-free rate of return), and E being the standard deviation of the rate of return of the portfolio under consideration.

A ratio greater than 1 means that the superior return of your portfolio relative to risk-free investment is not achieved at the expense of excessive risk. The higher the ratio, the better the portfolio.

A ratio of less than 1 means that the portfolio has a lower return than the risk-free investment. You should not invest.

A ratio between 0 and 1 means that the excess return over the risk-free rate is less than the risk taken.

To calculate the Sharpe ratio, you need to calculate the standard deviation of your portfolio. The standard deviation is a measure of volatility and is the square root of the average square of deviations from the mean over a given period of time (or the square root of the variance). Let’s take a concrete example. In the first 3 months of the year, the Dow Jones index shows a yield of 10%. Let’s assume that your portfolio 1 shows the following monthly returns for a 12% return:

– January: 10%.

– February: 5%.

– March: – 3%.

The average of the series is (10+5-3)/3 = 4%.

The deviation of the portfolio is : ((10-4)² + (5-4)² + (-3-4)²) / 3 = 28.66%

Therefore, the standard deviation is equal to: V(28.66%)= 0.5353

The Sharpe ratio of the strategy is therefore: (0.12/0.10) / 0.5353 = 2.24

Therefore, the return of your strategy is good in relation to the additional risk taken.

Let’s take another example of a portfolio this time with the following monthly returns for a 30% return:

– January: 20%.

– February: -15%.

– March: 25%.

The average of the series is (20-15+25)/3 = 10%.

The deviation of the portfolio is: ((20-10)² + (-15-10)² + (25-10)²) / 3 = 316.66%

Therefore, the standard deviation is equal to: V(316.66%)= 1.7794

The Sharpe ratio of the strategy is therefore: (0.30/0.10) / 1.7794 = 1.68

Therefore, the return of your strategy is good in relation to the additional risk taken.

Let’s take another example of a portfolio (3) with this time the following monthly returns for a return in the period of 12%:

– January: 20%.

– February: -7%.

– March: -1%.

The average of the series is (20-7-1)/3 = 4%.

The deviation of the portfolio is: ((20-10)² + (-7-10)² + (-1-10)²) / 3 = 170%

Therefore, the standard deviation is equal to: V(170%)= 1.3038

The Sharpe ratio of the strategy is therefore: (0.12/0.10) / 1.3038 = 0.92

Therefore, the return of your strategy is not good in relation to the additional risk taken.

Portfolios 1 and 3 have the same performance. Both outperform the CAC40 but portfolio 3 does so at the cost of excess risk. Portfolio 1 is therefore better than Portfolio 2.

Portfolio 2 has a much better return than Portfolio 1. However, Portfolio 1 is better than Portfolio 2.