Thanks for the excellent review, Alpha.
Quote:Colby favored high reward/risk ratio (total net profit to maximum equity drawdown).
Not good enough.
Given some luck, it is possible to have a historical maximum equity drawdown of $0. A system's large initial profit, can sometimes translate into a max equity drawdown of $0, even if it doesn't make another penny in profit for years to come and actually loses $ since the initial period.
This doesn't mean that the strategy is risk-free by any means.
Drawdown (i.e., the risk of losing all trading capital and going broke) should be measured from equity peak to trough, and the largest historical drawdown should then be used as the benchmark for possible future risk. After all, there is always the chance that the trader begins trading at the peak of the system's performance, and is looking at a major loss period ahead.
Sharpe ratio and other popular methods of measuring risk don't take into account real-world risk.
Quote:Dealing costs are ignored.
Big mistake.
Transaction costs (brokerage +
slippage, spread) take out a large chunk of profits, specially when trading regularly. It's not unusual to see total transaction costs of 10%pa for EOD strategies, and 20%pa or more for more active ones. Remember, these costs come straight out of profits, or worse, are added to losses.
By not including transaction costs, it's impossible to compare Buy & Hold with very active trading strategies, such as day trading.
Normalizing risk - comparing apples to apples.
Trading strategy results should always be normalized to risk before any comparison can be made.
Let's take these two theoretical strategy examples:
1) Trading strategy A averages 20%pa net profit with a maximum historical drawdown (capital peak to trough) of 50%.
2) Trading strategy B averages 10%pa with a max historical drawdown of 20%.
Directly comparing strategy profits A to B, would result in the mistaken view that A is twice as profitable as B - whereas in fact, a potential trader (assuming a sound mind) would scale back position size when trading the riskier system A. Decreasing position size will then result in reduced potential profits.
So, normalizing A and B profits to max historical risk (downsizing position size in A to match risk in B), would eventually equate with:
1) Trading strategy A now averages 8%pa with a normalized max historical drawdown (peak to trough) of 20%.
2) Trading strategy B averages 10%pa with a max historical drawdown (peak to trough) of 20%.
Therefore, after normalizing for risk, trading strategy B actually outperforms trading strategy A in the real world.
Buy & Hold and trading strategies cannot be compared directly without first normalizing to risk. Buy & Hold often carries large drawdowns.
More on this (and Relative Strength Comparisons) in an upcoming article in the Feb issue of
MSTT.
jose '-)
