How to differentiate good trading systems from the rest?

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Some of us may have had the luxury of choosing between two different automated trading systems which are both profitable (Isn’t that a good problem!). Perhaps you wish to try out one of them first and see how it performs. Problem is, how do you choose between the two?

​It is simpler than you think! Let’s go through the basics first, namely the Four Key Factors Of Evaluating Automated Trading Systems:

  • Expectancy of Trading System
  • Maximum % Drawdown
  • Type Of Equity Curves
  • Robustness Of System

Expectancy Of Trading System

Simply put:

Expectancy = % Winning Trades * Avg Profit/Loss Ratio


where:

Winning Trades = percentage of trades made that resulted in profits
Avg Profit/Loss Ratio = calculated by dividing average profit made and average loss made per trade

 

Picture this: You are having coffee/drinks with your friends and the topic of trading comes up. The most common way which your friend sizes you up as a trader is this “Hey, out of ten trades that you make daily/weekly, how many of these trades result in profits?”

If you say “Oh out of 10 trades? About 8-9 of them are profitable, thereabouts”, your friends will immediately accord you the Guru status in their mind, and the conversation will start veering toward “Hey teach me some of your secrets!”

Similarly, if you are shown two trading systems side by side, one showing you a win-rate of 90%, while the other system showing you a win-rate of 48%, which would you choose?

In most of the algo trading seminars where I asked this question, most participants naturally chose the first system with the 90% win-rate. I can even see their eyes light up emotionally as they make their choice!

Now let’s add in more information regarding the two trading systems:

System #1

​Win-Rate = 90%
Avg Profit = $100
Avg Loss = $400

System #2

Win-Rate = 48%
Avg Profit = $150
Avg Loss = $100

Now, with these new information, would you still go for System #1? Or does System #2 now seem much more profitable and make more sense?

When I first showed one of my friends who have no prior knowledge of trading, he asked me “I can see that System #2 does looks like it has more potential than #1 now, but are you sure that System #2 really is more profitable?”

That was when I realised how emotionally powerful a win-rate of 90% can have on the unsuspecting human mind. Thus, in order to remove all doubts, let’s calculate the Expectancy using the formula above:

Expectancy of System #1
= 0.90 * 100/400
= 0.225

Expectancy of System #2
= 0.48 * 150/100
= 0.72

​See how much higher the Expectancy for System #2 is as compared to System #1? We are looking at System #2 being more than 3x more profitable than System #1!

 

Maximum % Drawdown

Now that we know how you can scientifically evaluate the “Profitability” of trading systems, let’s move on and understand a simple way to gauge the potential “Risk” of trading systems.

To understand risk, we first need to define what a “Drawdown” on your account equity means. Simply put, a Drawdown is the peak-to-trough decline​ of your account equity (account balance plus any unrealised profit/loss).

It’s easier to see this in graphically:

The above picture shows how your account equity has fluctuated with trading profits and losses. When you have a string of losses, the account equity goes down and thus creates a Drawdown (measured from the peak to the next lowest trough). We then look for the largest drawdown by percentage, and that becomes our “Maximum % Drawdown”.

This number tells us the percentage loss we can potentially incur on our capital when we use the trading system. Note that this number is not set in stone, and is simply a gauge of what to expect in future.

So, what is a good “Maximum % Drawdown” to have? Granted, in an ideal world, the lower this is, the better. Practically though, any experienced trader worth their salt will tell you this: “In trading, there are bound to be losses along the way, it is just a fact of life. Our job is simply to keep these losses contained within reasonable means. Once we succeed in doing that, the profits will take care of itself.”

For our automated trading systems, we design each of them to keep their maximum % drawdown potentially at about 15%. We found that this is a good balance between keeping consecutive losses at a tolerable level, and maximizing the potential profits (about 40-50% per annum).

To put things in perspective, I was looking at one of my favorite retail trust fund that I have invested quite a bit before. The average annual returns is at 9.9% per annum, with a maximum drawdown of… 56%!

We are now starting to see why mutual funds & unit trusts are starting to feel threatened by algorithmic trading systems.

 

Type Of Equity Curves

Equity Curves shows you how your account balance + unrealised profits/losses fluctuate over time.

There are three main types of equity curves. The first type is usually the result of a range-trading strategy. Trades taken have pretty much a 50/50 chance of resulting in profits. The system simply ensures that the average profit is larger than the average loss, resulting in an upwards equity curve over time:

The second type of equity curve which is shown below, has the appearance of “steps” which slopes downwards. This is usually created by a trend-trading strategy, where the trading system takes small trades with tight stop loss, waiting to take advantage of a large new trend. If the new trend emerges, it will result in a large profit, shown by the steep move upwards after each “step”:​

Lastly, the third equity curve looks like this:

Now, raise your hands if you love this equity curve!

When I ask this question during my algo trading seminars, I can literally see the a twinkling of the eyes coming from most participants, with a small handful of them smiling, thinking I am finally going to reveal “The Holy Grail”, that magic that will allow us to keep on making profits without losses.

Sometimes, someone from the audience will shout out: “So, what’s the catch?”

The catch is this:​

What happens is that, at a certain undetermined time in the future, the system will suddenly accumulate losses so huge, it will simply wipe out the whole account instantly. So what is going on here?

​These strategies are commonly known as “grid strategies” and “martingale strategies”. The general concept is that they try to only close positions that are in profit, or those only showing small losses. If the positions are running large unrealized losses, they will continue to hold on to the position, hoping that the market will start moving back in their favor, so that the unrealized losses turns into profits. Should the market continue to move in the opposite direction, the unrealized losses will accumulate more and more. When this reaches a breaking point, their account will get into a margin call situation, and any worsening will result in a margin stopout, thereby closing all positions and realizing all the unrealized losses.

Martingale (or any variations of Martingale) accelerates the path towards the breaking point, as it doubles or increases the position sizes of new positions when existing positions with unrealized losses are kept running in the account.​

In today’s market, about 6-7 out of 10 automated systems belong to this third category. The main reason is that it is so easy to show potential clients how safe and reliable their trading system is, with a near-perfect trading track record, generating extremely high returns, coupled with extremely low risks. The only information conveniently left out is the fact that when the music stops, all the capital in the trading account will be wiped out.

Thus, whenever you see such a tempting and impossible looking equity curve, run away as far as you can. Only go for strategies that result in the first two types of equity curves.

 

Robustness Of System

The final factor for evaluating an automated trading system is “Robustness”, and this is one of the hardest to determine.

One of the facts of life in the world of trading is that, the market is dynamically changing month after month, year after year. It is literally a reflection of the cumulative psychology of all the market participants.

Robustness, simply means how well the trading system can perform, even when the market conditions have changed significantly. If a system was designed ground up with robustness in mind, then even when market conditions have changed much over the years, it can potentially continue to be profitable in the new market conditions.

Phew, this article sure was a mouthful! If you like what we are sharing here, please check out the rest of our articles on algorithmic trading here:
5 most useful indicators on the MT4 platform
Part 1 – How To Create a Free VPS on Google Cloud for MT4 EAs

Do also check out our preferred broker IG (click here). Listed on London Exchange, they are among the largest forex and CFD brokers worldwide. We are currently running our algorithmic trading systems on IG live accounts, performance can be seen here: myfxbook – GS Alpha Bundle Portfolio

 

This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views, opinions and recommendations expressed in the article are the independent opinion of Guiding Star Technologies and do not in any way reflect the views, opinions, endorsements or recommendations, of IG Asia Pte Ltd (Co. Reg. No. 20051002K) (“IG”). Information is for educational purposes only and does not constitute any form of investment advice nor an offer or solicitation to invest in any financial instrument. No responsibility is accepted by IG for any loss or damage arising in any way (including due to negligence) from anyone acting or refraining from acting as a result of this information or material.

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