Evaluating the strength of a trading strategy

While working on different strategies with my new backtesting tool (see older post for description), I figured I need to have one main criteria to compare and evaluate different approaches. I couldn't find satisfying ideas on the internet so I created my own performance index.

Of course there are many different aspects to look at when evaluating a strategy: How good is the point of time for opening a trade? How many trades are opened and how many of them are closed with profit? How many fees does the strategy "create"? What is the maximum loss per trade? What is the maximum drawback? And so on...

But at the end I don't want to measure my strategy on the number of positive trades but on the profit I made by applying it to the market. So I need to compare my equity at the beginning and at the end. If the equity is higher at the end than at the beginning, I made profit. The higher the profit the better the strategy. But I think it is also essential to compare the strategy performance to the performance of the underlying asset. Here is an example: When trading on the german DAX (Ger30) from 1992 to 1995, the index itself had a 56% value increase. So even with a bad strategy it was easy to generate a remarkable gain of 20% and more. Still less than the DAX itself though. That means a simple buy-and-hold strategy would have resulted in a higher profit.

I want to consider that in my performance index so I developed the following formula:

  DPI = f_equity/f_asset * sign(f_equity-1)
 with
 f_equity = {equity at the end}/{equity at the beginning}
 f_asset = {value of asset at the end}/{value of asset at the beginning}

The following picture further explains how to interpret the values of the DPI:

• DPI >1: Strategy is profitable and performing better than asset (asset is possibly lossy)
• 0<DPI<1: Strategy is profitable but performing worse than asset
• DPI = 0: Strategy and asset have exactly the same starting and closing value
• -1<DPI<0: Strategy is lossy and loses more than asset (asset is possibly profitable)
• DPI<-1: Asset and strategy are losing, but strategy performs better than asset

 

So generally the grey shaped area in the above picture is the target zone for the DPI, where the stratey is profitable and better than the underlying asset. In my opinion, a good trading strategy should have a DPI>>1. Even a DPI close to 1 is not satisfying considering the time for developing and applying a strategy compared to the time necessary for a buy-and-hold-strategy.


***

Related posts:

Strategy backtest pt.5 - market trend

Strategy backtest pt.4 - short trades

strategy backtest pt.2

Evaluating the strength of a trading strategy
backtesting tool V2
First trading strategy backtest

***

Important remark: The results presented above and throughout my blog are no recommendation for your trading! I only share my personal findings and opinions to give ideas and let my followers and copiers know what I am currently working on. I can not guarantee the correctness of my calculations and my presented results. Furthermore past performance is not an indication for future results. Only trade with money you are prepared to lose!