Analysing monthly forex trading performance in changing market conditions

In my previous post, I discussed about [3 reasons why I don't use Jensen's alpha or Sharpe ratio for my montly trading performance measurement][]. In this post, I will talk about what I actually use and how I came up with it. As I was saying in the previous post, what one chooses to use as their performance metric depend on 3 factors such as your style of trading, your agenda, and your interest in this topic. I will briefly lay out my 3 motives as background information. I use a swing trading strategy for trading forex. I aim to hold for at least a few hours to a few days. I am working to hold longer and trade less in the future, but that's another story. To fit my style of trading, a performance metric has to be unbiased for long and short trades as well as taking into account short term conditions in the market. In terms of agenda, what is the purpose of my performance metric? As a part-time trader, I answer only to myself. These numbers are used for my self-improvement and internal month-to-month comparisons only. Lastly, my interest in this topic of portfolio measurement is limited. I want something easy to calculate and simple to understand. I have read a few academic papers on this topic and spent a few hours researching on the web. That's about it. Now that my motives have been laid out, let's discuss my process for coming up with my trading performance metric. Ultimately, my assessment on how well I have done for the month is to measure my return based on the risk taken. In other words, Performance Metric = Reward / Risk. My Reward function is simple. I just steal the idea from Sharpe and use: > Reward = Net Return - Riskless Return Shameless. I know. I don't want to muck with the Reward function because at the end of the day, it is your account balance that matters. The Risk function takes some more thought. On a trade-by-trade basis, the risk taken for a particular trade can be thought of as the stop loss. It is a amount put at risk to be taken by the market. In other words, risk can be represented by the loss you are willing to take. On a month-to-month basis, the most important loss value that I pay attention to is my maximum drawdown. A drawdown imposes a real dent in your account as well as negatively impact your trading psychology. For these reasons, the maximum drawdown is a variable in my Risk function. > Risk = Max. Drawdown ... However, I am not done yet. While max. drawdown is important, it is an entirely internal factor. The risk you take is also affected by the condition of the market. Using the stop loss analogy again, a 50 pips stop loss can be labelled as both conservative and aggressive risk exposure depending on the volatility of the market in the timeframe you're trading. As such, we need to consider volatility in the Risk function. However, this raises another question, what is volatility. Long story short, I just snatch the Average True Range (ATR) indicator that I use on my charts in this formula. However, we can't just stick a ATR value in because it's an absolute number. We need to use a percentage ATR (%ATR) to correspond with all the other percentage numbers in the formula. And since this is for monthly analysis, I grab the %ATR from a monthly chart. In particular, I use the monthly %ATR on the U.S. dollar futures chart. Finally, the Risk function is: > Risk = Maximum Drawdown + %ATR Thus, > **Performance Metric = (Net Return - Riskless Return) / (Maximum > Drawdown + %ATR)** As an example, here are the values I plug in for each variable to calculate my performance metric for [November][]. Net Return = 3.15%, read from November's statement Riskless Return = 0.54% (per annum) / 12 = 0.045%. This is the Canadian 1-year treasury rate in November. Max. Drawdown = 3.55%, read from November's statement %ATR = monthly ATR(3) of U.S. dollar futures / monthly close of U.S. dollar futures = 3.1473/74.895. To verify the efficacy of this performance metric. Let's do a mental check of my criteria as discussed. 1. Unbiased for long and short trades? Yes, it uses the net return regardless of which side you took. 2. Varies with short term market conditions? Yes, from the %ATR. 3. Comparable between month to month? Yes, the number is normalized by market volatility each month. 4. Easy to calculate? Yes, it's can be done in my [trade log][] spreadsheet with a few formulas. 5. Easy to understand? Yes, it's an interpretation of reward / risk. As with any other attempt to summarize trading performance into one single value, many assumptions have been taken. I cherry picked what I needed to assemble a formula. Some observant reader will notice that this formula is similar to the Sterling and Calmar ratios. Indeed, this is yet another modified form of these ratios. In fact, I will be referring to this formula as Sterling ratio in my future posts for simplicity.

[3 reasons why I don't use Jensen's alpha or Sharpe ratio for my montly trading performance measurement]:

3 reasons why I don't use Jensen's alpha or Sharpe ratio for my forex trading

As a part-time trader, measuring my monthly trading performance can be as simple or as complex as it can be. On a scale of 1 to 10, 1 being just reading the percent return from the account statement and 10 being running a statistical analysis, my preferred trading performance measurement method is a simple 3. I am lazy but want a metric that is useful for monthly self-evaluation. That is why Jensen's alpha or Sharpe ratio have appealed to me. Both of these ratios are can be easily derived. However, 3 shortcomings of these metrics made me decide not to use them for my forex trading. First is the fact that they emphasize excess return with respective of the market. It makes sense to compare a portfolio with the overall market on a long term basis. But what if you want to do month-by-month, or even week-by-week analysis? Short-term market volatility could skew your performance metric up/down even when you have been performing consistently. Furthermore, what if it is an out-right bear market? Your short-side strategy would be boosted by the negative return of the market. For a swing trader such as myself, a shorter time-frame and long/short unbiased measurements are non-trivial matters for analysing trading performance. Secondly, neither metrics factor in volatility of a market. A 5% return in a calm market is not the same as 5% in a volatile market. If you go out to fish in a storm, you'd better expect a huge payout to compensate for the extra risk. Lastly, I don't like their definition of risk. For me, a short-term performance ratio can sufficiently be characterized as reward / risk. Jensen's alpha calculation has no explicit measurement of risk at all. Whereas Sharpe takes the standard deviation of the portfolio's return as the risk value. For a monthly analysis, I would have to use a daily or weekly drawdown to calculate the standard deviation. The problem with using the daily is that it's too much work for me to do manually on my spreadsheet. As for the weekly, having just 4 weeks in a month is not a sufficient sampling size to calculate a representative standard deviation. In summary, here are my 3 reasons for not using Jensen's alpha and Sharpe ratio.

  1. Emphasis on excess return with respect to the market
  2. No consideration for volatility of the market
  3. Not agreeing on their definition of risk

On the other hand, there are numerous reasons why these metrics are the standard portfolio measurments used by many traders. Heck, Jensen's alpha and Sharpe ratio have been around for 40 years and are still widely in use today. However, they are just not suitable for me as discussed. The thing is, there are countless number of new and old portfolio measurements out there. What one chooses to use depend on various factors such as your style of trading, your agenda, and your interest in this topic. In my next post, I will introduce the metric that I use for my monthly trading performance analysis -- a modified Sterling ratio.