BUT DID YOU MAKE MONEY? EVALUATING PERFORMANCE

BUT DID YOU MAKE MONEY? EVALUATING PERFORMANCE


Any one trade involves a lot of variables: price bought, price sold, commissions charged, volume traded, and amount of leverage used. And each of these affects your overall performance. In the heat of a trading day, it can be hard to juggle all these factors and determine just how well you did or did not do.

Performance calculation starts before you trade. You want to test your strategies and see if they work for you, which requires backtesting and paper trading. You want to keep track of your trades in real time with the help of a trading diary. And then, on a periodic basis, you should review your progress to see how much money you are making and whether you need to change your strategy.

Before You Trade: Testing Your System

Performance measurement starts before the trading does. That’s because you want to figure out how you will trade before you start betting real money. Some of the different securities that can be traded on a daily basis, whereas some of the strategies that day traders use. After you figure out the combinations of securities and strategies you want to use, you’ll want to see whether they would have made you money in the past. Then you should try them out to see if they still work now.

The happy news? All this is possible without risking a dime, except of course for the money you might spend on backtesting and simulation software. You knew there had to be a catch, right? Consider it an investment in the success of your business.

Backtesting

In backtesting, a trader specifies the strategy that he or she would use and then runs it through a database of historic securities prices to see whether the strategy would have made money. The test includes assumptions about commissions, leverage, and position size. The results give information on returns, volatility, and win-loss ratios that can be used to refine a trading strategy and implement it well.

Starting with a hypothesis

What trades do you want to do? After you figure out what and how to trade, you can start setting forth what your strategy will be. Will you look for highmomentum, small-cap stocks? Seek out price changes related to news events in agricultural commodities? Ride large-cap stocks within their ranges? Arbitrage stock index futures and their options?

Once you have done your research, you can lay out your strategy as a hypothesis. It might be something like this: “High-momentum, small-cap stocks tend to close up for the day, so you can buy them in the morning and make money selling them in the afternoon.” Or: “News events take at least half an hour to affect pork belly prices, so you can buy or sell on the news and make a profit.” With this statement, you can move on to the test to see if it holds.

One of the most valuable parts about backtesting is that you have to be very specific about what your trading rule is. Computers cannot understand vague instructions, and if you find that your trading strategy is too complicated to write out and set into a backtesting program, it’s probably too complicated for you to follow.

Running the test

Let’s say you start with something simple: Maybe you have reason to think that pharmaceutical companies that are moving down in price on decreasing volume will turn and close up for the day. The first thing you do is enter that into the software: the industry group and the buy pattern that you’re looking for. The results will show whether your hunch is correct, and how often and for what time periods.

If you like what you see, you can add more variables. What happens if you add leverage in your trades? That increases your risk of loss, but it also increases your potential return. How does that affect your trade? Suppose you increase the size of your trades. Would that help you make more money or less? By playing around with the system, you can get a good sense of the best way to make money with your trade ideas. You can also get a sense of when your rule won’t work, to help you avoid problems.

Most backtesting software allows for optimization, which means that it can come up with the leverage, position, holding period, and other parameters that will generate the best risk-adjusted return. You can then compare this to your trading style and your capital position to see if it works.

Backtesting is subject to something that traders call over-optimization, mathematicians call curve-fitting, and analysts call data mining. This means that the person performing the test looks at a past time where the market performed well, then identifies all the variables and specifications that generated that performance. Although it sounds great, what often happens is that the test generates a model that includes unnecessary variables and that makes no logical sense in practice. If you find a strategy that works when the stock closes up one day, down two days, then up a third day, followed by four down days when it hits an intra-day high, you probably haven’t made an amazing discovery — you’ve just fit the curve.

People with iPods and MP3 players have elaborate ideas of how the machines’ “random shuffle” feature works. Ask, and they’ll give you their own elaborate theory for how certain types of songs show up more often than others, how songs with similar titles seem to be played together, and other patterns that they are sure must be there. Why? Because human beings have evolved to see patterns, even when none is there. It’s the same with the market. It’s entirely possible that although the results of your test look great, but they only show a random event that happened to work out once. That’s why you need to keep testing, even after you start trading.

Comparing the results with market cycles

The markets change every day in response to new regulations, interest rate fluctuations, economic conditions, nasty world events, and run-of-the-mill news events. Different securities and strategies do better in some market climates than in others.

When you are backtesting, it’s important to do it over enough time so that you can see how your strategy would work over different market conditions. Here are some things to check:
  • How did the strategy do in periods of inflation? Economic growth? High interest rates? Low interest rates?
  • What was happening in the markets during the time that the strategy worked best? What was happening when it worked worst? How likely is either of those to happen again?
  • How does market volatility affect the strategy? Is the security more volatile than the market, less volatile, or does it seem to be removed from the market?
  • Have there been major changes in the industry over the period of the test? Does this mean that past performance still applies?
  • Have there been changes in the way that the security trades? For example, the bulk of trading in most commodities used to take place in openoutcry trading pits. Now, it’s mostly electronic. Does that change affect your test results?

In the Capital Assets Pricing Model, which is a key part of academic finance theory, the market risk is known as beta. The value that a portfolio manager adds to investment performance is known as alpha. In the long run, conventional finance theory says that the return on a diversified portfolio comes from beta; alpha does not exist. In the short run, where day traders play, this relationship might not be so strong.

Past performance is not indicative of future results. A strategy may test perfectly, but that doesn’t mean it will continue to work. Backtesting is an important step to successful day trading, but it is only one step.

Simulation trading

With a backtested strategy in hand, you might be tempted to start putting real money on the line. Don’t, just yet. Start with what is known variously as ghost trading, paper trading, and simulation trading. Sit down in front of your computer screen and start watching the price quotes. When you see your ideal entry point, write it down. When you see your exit point, write it down. Do exactly what you plan to do with real money, just don’t use the money. Then, figure out what your performance would have been.

If your strategy does not generate a lot of trades, you can probably keep track with a pen and paper and then enter the data into a spreadsheet to calculate the effects of commissions and leverage and to analyze the performance on both a percentage and a win-loss basis. For more complex strategies that involve a large number of trades on a large number of securities, you might want to use simulation software. These are trading simulation software packages that mimic trading software. They let you enter the size of your order, let you use leverage, and tell you whether your trade can be executed given current market conditions.

Markets are affected by supply and demand, and your trade can affect that. And that’s the biggest drawback of simulation trading: It’s difficult to take the market effects of your trade into account in any reliable way.

The results of your trading simulation can help you refine your trading strategy further. Does it work in current market conditions? Are you able to identify entry and exit points? Can you make enough trades to make money to make your day trading efforts worth while? Do you want to refine your strategy some more, or are you ready to go with it?

It may take a long time to find a suitable strategy. Some traders report spending months finding a strategy they felt comfortable using. Day trading is a business like any other. Consider this part of the market research and education process that you need to go through, just as you would have to spend time doing research before opening a store or training for a new career. Stay patient. It’s better to do good simulation for months than to lose thousands of real dollars in hours.

Backtesting and simulation software

Several vendors have risen to meet the challenge of backtesting. The list in this section is by no means exhaustive, nor is it an endorsement of their services. It’s just a good place for you to start your research.

If you are just getting started with trading, you may want to work with a cheaper package just to see how it works. If you already have an account with a brokerage firm, check to see if backtesting and simulation are among the services offered. You can always move up as your needs change or if you start pursing exotic strategies with unusual securities.

AmiBroker

AmiBroker offers a robust backtesting service at a relatively low price. This makes it a popular choice with people who are getting started in day trading and who don’t have more expensive services. It also allows users to make sophisticated technical charts that they can use to monitor the markets. One drawback is that you might have to pay extra for the market price quote data, depending on what securities and time periods you want to test.

Cybertrader

Cybertrader is Charles Schwab’s product for active traders. Its Strategy Tester feature lets you test your trading idea. Then you can set it into a Strategy Ticker that follows your strategy while the market is open, so that you can see how it performs in real time. This isn’t quite the same as paper trading, as it isn’t testing how well you would pull the trigger, although presumably you would buy or sell whenever your system told you to — right?

Tradecision

Tradecision’s trade analysis software package is a little pricier than most retail trading alternatives, but it offers more advanced capabilities, including an analysis of the strengths and weaknesses of different trading rules. It can incorporate advanced money management techniques and artificial intelligence to develop more predictions about performance in different market conditions. The system may be overkill for most new day traders, but it could come in handy for some.

TradeStation

TradeStation is an online broker that specializes in services for day traders. Its strategy testing service lets you specify different trading parameters and then it shows you where these trades would have taken place in the past using price charts. That way, you can see what would have happened, which is helpful if you are good at technical analysis. It also generates a report of the strategy, showing dollar, percentage, and win-loss performance over different time periods. It does not have a trade simulation feature.

If you have the programming expertise, or if your strategy is not well represented in current backtesting programs, you might want to create your own system. Many software-savvy day traders write programs using Excel’s Visual Basic functions, allowing them to create custom tests that they then run against price databases.

During the Day: Tracking Your Trades

Once you put your strategy to work during the trading day, it’s easy to let theenergy and emotion overtake you. You get sloppy and you stop keeping track of what’s happening. And that’s not good. Day trading is not a video game, it’s a job. Keeping careful records helps you identify how well you follow your strategy and helps you identify ways to refine it. It can also show you how successful your trading is, and it makes your life a lot easier when it’s time to do your taxes.

Setting up your spreadsheet

The easiest way to get started is with a spreadsheet software program such as Microsoft Excel. Set up columns for the asset being purchased, the time of the trade, the price, the quantity purchased, and the commission. Then set up similar columns to show what happens when the position is closed out. Finally, calculate your performance based on the change in the security’s price and the dollars and percentage return on your trade.


Some brokerage firms and trading platforms automatically store your trade data for analysis. You can then download the data into your own spreadsheet or work with it in your trading software. If you make too many trades to keep track of manually, then this feature will be especially important to you.

Profit and loss statement

If you look at the bottom, you’ll see some quick summary statistics on how the day’s trading went: trading profits net of commissions, trading profits as a percentage of trading capital, and the ratio of winning to losing transactions. This information should be transferred into another spreadsheet so that you can track your ongoing success.

Calculate your hourly wage for each day that you trade. Simply take each day’s profit and divide it by the number of hours that you worked. That number, more than any other, will help you see whether it makes sense for you to keep trading or if you’d be better off pursuing a different line of work.If you find that calculating the number daily is too stressful, try doing it monthly.

The trading diary

As part of your trading spreadsheet, or in addition to it, you should track the reasons for making every trade. Was it because of a signal from your system?

Because of a hunch? Because you saw an opportunity that was too good to pass up? Then you can keep track of how the trade worked out. Is your trading system giving off good signals? Are you following them? Are your hunches so good that maybe your system needs to be refined? Are you missing good trades because you are following your gut and not the data in front of you?

A trading diary gives you information to systematically assess your trading. Start by writing down why you are making a particular trade and do it when you make the trade. Trust me, if you wait until later, you’ll forget and you’ll change your logic to suit your needs. You can enter the information in a spreadsheet, jot something quick on a piece of scratch paper, or keep a notebook dedicated to your trading. It doesn’t have to be fancy, as long as you take the time to make the notes so that you can refer back to it.

Some traders create a form, make copies of it, and keep a stack of them on hand so that they can fill them out easily during the day. They even create predetermined indicators that match their strategies and that they can check off or circle. At the end of the day, they collect their diary sheets into a three ring binder in order to refer back to the data when it’s time to evaluate their trading strategy and their performance against it.

The trading diary form is just an example. If your trading style is so fast that you don’t have time to fill it out, don’t fret — come up with some kind of shorthand so that you can keep a running tally of trades made based on a signal from your system, trades based on your own hunches, and trades based on other interpretations of market conditions. Then match your notes against the trader confirmations from your broker to see how you did.


After You Trade: Calculating Overall Performance

Calculating performance seems easy: Simply use the balance at the end of the year and the balance at the start of the year to find the percentage change. But what if you added to your investment in the middle of the year? What if you took cash out in the middle of the year to buy a new computer? Quickly you’re left with algebra unlike any you’ve seen since high school, but you need to solve it to see how you are doing.

In addition to the increase in your assets, you want to track your volatility, which is how much your gains and losses can fluctuate. It’s an important measure of risk, especially if your trading strategy relies on leverage.

Types of return

The investment performance calculation starts by dividing returns into different categories: income, short-term capital gains, and long-term capital gains.

Although almost all a day trader’s gains will come from short-term capital gains, I go over the definitions of each so that you know the differences.

Income

When investors talk about income returns, they mean regular payments from their investments, usually in the form of dividends from stock or interest payments on bonds. As a day trader, you may earn income on the cash balance in your brokerage account, but probably not from your trading activities.

Capital gains

A capital gain is the price appreciation in an asset — a stock, a bond, a house, whatever it is that you’re investing in. You buy it at one price, sell it at another, and the difference is a capital gain. (Unless, of course, you sell the asset for less than you paid, and then you have a capital loss.)

For tax purposes, capital gains are classified as either long-term or short-term. Under the current tax law, any capital gain on an asset held for less than one year is considered to be a short-term gain, and if the asset is owned for one year or more before it’s sold, then it’s considered to be a long-term capital gain. The difference isn’t semantic — long-term capital gains are taxed at lower rates than short-term capital gains.

Income in tax terms is different from income in financial terms. Much of what an investor would consider to be a capital gain, such as the short-term capital gains that day traders generate, the IRS considers to be income.

Calculating returns

Give someone with a numerical bent a list of numbers and a calculator, and she can some up with several different relationships between the numbers. Once the asset values for each time period have been determined, rates of return can be calculated. But how? And over how long a time period? The process gets a little more complicated.

Percentage change

The most common way to calculate investment returns is to use a time-weighted average. It’s perfect for traders who start with one pool of money and do not add to it or take money out. This is also called the CompoundAverage Rate of Return (CAGR). If you are looking at only one month or one year, it’s a simple percentage.


EOY stands for end of year asset value and BOY is beginning of year value. The result is the percentage return for one year, and it’s simple arithmetic.

Now, if you want to look at your return over a period of several years, you need to look at the compound return rather than the simple return for each year. The compound return shows you how your investment is growing. You are getting returns on top of returns, and that is a good thing. But the math gets a little complicated, because now you have to use the root function on your calculator. 

EOP stands for end of the total time period, BOP stands for beginning of the total time period, and that N is the number of years that we’re looking at.


The basic percentage rate of return is great; it’s an accurate, intuitive measure of how much gain you’re generating from your trading activities. As long as you don’t take any money out of your trading account or put any money into it, you’re set.

However, you may be putting money into your account. Maybe you have a salaried job and are day trading on the side, or maybe your spouse gives you a percentage of his income to add to your trading account. You might also be taking money out of your day trading account to cover your living expenses or to put into other investment opportunities. All that money flowing into and out of your account can really screw up your performance calculation. You need a way to calculate the performance of your trading system without considering the deposits and withdrawals to your trading account.

As a day trader, you have a few methods at your disposal for calculating your performance when you make withdrawals and deposits:

  • The Modified Dietz method loses a little accuracy but makes up for it with simplicity.
  • The time-weighted rate of return isolates investment and trading performance from the rest of the account.
  • The dollar-weighted rate of return has many flaws but gives a sense of what the account holder has.

Modified Dietz method

The Modified Dietz method is related to the simple percent change formula, but it adjusts the beginning and ending period amounts for the cash inflows and cash outflows.


So with the number in our example, it would look like.


And that equals 19.8 percent.

The advantage of the Modified Dietz method is that it so easy to do. You can calculate it to give you a rough idea of how you are doing with your trading when you don’t have the time to run a more detailed analysis. The key disadvantage is that it doesn’t consider the timing of the deposits and withdrawals. It would generate the same answer if you took out $5,000 in May and put in $1,000 in December, even though the amount of money you would have to trade between May 1 and December 1 would be very different.

Time-weighted rate of return

The time-weighted rate of return shows the investment performance as a percentage of the assets at hand to trade. It’s the standard of trader evaluation, but the math is much more complicated than with the basic percentage change or the Modified Dietz method. You need to calculate the CAGR for each time period and then do a second calculation to incorporate each of those over a longer period. Using our example, you’d calculate one return for the first four months of the year, another for the next seven months, and then a third return for the month of December. These three returns would be then be multiplied to generate a return for the year.

The general equation look like.


N is the total number of time periods that you are looking at, and rpn is the return for that particular time period. To make it easy, you can do the calculation in a spreadsheet. Shows the time-weighted return for this example.


The result is 18.78 percent, a little below the Modified Dietz return.

If you plan on adding to or taking money out of your account, you can make your return calculations much easier by setting a regular schedule and sticking to it. Otherwise, you’ll have to do calculations for fractional time periods. It’s not impossible, but it’s kind of a hassle.

The time-weighted rate of return gives you the best sense of your trading performance, and its precision for this use more than offsets the complexity of the calculation. You want to look at this number when you are deciding whether to change or refine your strategy.

Dollar-weighted returns

The dollar-weighted return, also called the money-weighted return, is the rate that makes the net present value of a stream of numbers equal to zero. That calculation is also called the internal rate of return or IRR, and it is used for other things than just return calculations. It’s a way of determining what the return is for a stream of numbers over time, and it’s useful for calculating returns when you’re putting money into or taking money out of your trading account. And if you have a financial calculator such as the Hewlett-Packard HP12C or the Texas Instruments BA2+, it’s pretty easy to calculate.

Ah, but there’s a catch! Although it’s useful, the dollar-weighted method can misstate returns and can occasionally show nonsensical results if there are too many negative returns in a series. And yes, day traders often have negative returns. Shows the dollar weighted rate of return using the same data used in the two examples.

The result is 12.1 percent, lower than the other two examples because the dollar-weighted return overstates the withdrawal and the loss in the last month of the year. The withdrawals affect the account’s spending power, offsetting the investment performance. But the overall account balance is up more than 12.1 percent, even considering the deposit at the beginning of May — the weight of the cash flows threw off this calculation.

Because of the problems with dollar-weighted returns, professional investors who analyze investment returns usually prefer the time-weighted, compound average approach. Still, the dollar-weighted return has some value, especially for an investor who wants to know how the asset value has changed over time. Because a day trader is usually both an investor and an account owner, the dollar-weighted rate of return can show whether the investment performance is affecting spending power. This measure is particularly useful if you are trying to decide whether to continue day trading

Just as you have alternatives in calculating your performance, so too does anyone trying to sell you a trading system or training course. Ask questions about the performance calculation method and how cash flows and expenses are handled. The numbers might not look so great once you grade the math behind them.

The risk to your return

Now that you have return numbers from your profit and loss statements and your return calculations, it’s time to perform black-belt performance jujitsu and determine your risk levels. I’m not going to go into all of the many risk and volatility measures out there, because believe me, the good editors of the ...For Dummies books don’t want to proofread all the math.

Batting average

Baseball players are judged by how often they hit the ball. After all, they can’t score until they get on base, and they can’t get on base without a hit or a walk. The number of hits relative to the number of times at bat is the batting average. It’s a simple, beautiful number.

Day traders often calculate their batting average, too, although they might call it their win-loss percentage or win ratio. It’s the same: the number of successful trades to the total number of trades. Not all trades have to work out for you to make money, but the more often the trades work for you, the better your overall performance is likely to be. If you have both good performance and a high batting average, then your strategy may have less risk than one that relies on just a handful of home run trades amidst a bunch of strikeouts.

Standard deviation

Want something harder than your batting average? Turn to standard deviation, which is tricky to calculate without a spreadsheet but forms the core of many risk measures out there.

The standard deviation calculation starts with the average return over a given time period. This is the expected return, the return that, on average, you get if you stick with your trading strategy. But any given week, month, or year, the return might be very different from what you expect. The more likely you are to get what you expect, the less risk you take. Insured bank savings accounts pay a low interest rate, but the rate is guaranteed. Day trading offers the potential for much higher returns, but also the possibility that you could lose everything any one month — especially if you can’t stick to your trading discipline.

In Step One, you take every return over the time period and then find the average. A simple mean will do. Here, there are 12 months, so I added all 12 returns and then divided by 12.

In Step Two, you take each of the 12 returns and then subtract the average from it. This shows how much any one return differs from the average, to give you a sense of how much the returns can go back and forth.

In Step Three, you take each of those differences and then square them. This gets rid of the negative numbers. When you add those up, you get a number known in statistics as the sum of the squares.

Now you have enough for Step Four: taking the average of the sum of the squares.

And for Step Five: the square root of the average of the sum of the squares. That square root from Step Five is the standard deviation, the magic number we’re looking for.

Of course, you don’t have to do all of this math. Almost all trading software calculates standard deviation automatically, but at least you now know where the calculation comes from.

The higher the standard deviation, the riskier the strategy. This number can help you determine how comfortable you are with different trading techniques you might be backtesting, as well as whether you want to stick with your current strategy.

In academic terms, risk is the likelihood of getting any return other than the return you expect. To most normal human beings, there’s no risk in getting more than you expect — the problem is in getting less of a return than you were counting on. This is a key limitation of risk evaluation.

Past performance is no indicator of future results. That truism applies to risk as well as to return.

Using benchmarks to evaluate your performance

To understand your performance numbers, you need one more step: what your performance is relative to what else you could be doing with your money.

Performance relative to an index

The most common way to think about investment performance is relative to a market index. These are the measures of the overall market that are quoted all the time in the news, such as the Standard & Poor’s 500 and the Dow Jones Industrial Average. Not only are these widely watched, but many mutual funds and futures contracts are designed to mimic their performance. That means investors can always do at least as well as the index itself, if their investment objectives call for exposure to that part of the broad investment market.

Indexes aren’t perfect. One big problem is that day traders often look at the wrong index for the type of investment that they have. They’ll compare the performance of trading in agricultural commodities to the Standard & Poor’s 500 when a commodities index would be a better measure.

If you aren’t sure what to use, pick up a copy of Barron’s, a weekly financial publication put out by Dow Jones & Company, the same people who publish The Wall Street Journal and the Dow Jones Industrial Average. In the Market Lab section there is a long list of different stock, bond, and commodity indexes for the United States and the world. You can find the one that best matches your strategy and use it to compare your performance.

In some cases, your trading practices may overlap more than one index. If so, pick the indexes that are appropriate and compare them only to those trades  that match. If you trade 40 percent currencies and 60 percent metals, then you should create your own hybrid index that’s 40 percent currencies and 60 percent metals.

Performance relative to your time

A few pages back when I talk about tracking your trades and doing a profit and loss statement, I say that you should calculate your hourly wage. There’s a reason for that. Instead of day trading, you could put your money in a nice, simple, index mutual fund and take a regular job. If your hourly wage is less than what you can earn elsewhere, you might want to consider doing just that.

Of course, there are benefits to working on your own that don’t often show up in your bank account. I say this as someone who left finance to be a financial writer. If you enjoy day trading and if you make enough money to suit your lifestyle, by all means, don’t let the relative numbers stop you.

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