6 RISK AND REWARDS GAUGES.
Moreover, in the statistics tab of the performance report you will find six gauges which describe the risk and reward profile of the signals as implied by the CumulativeProfit% curve. These are:
HISTORICAL EDGE OF THE SIGNALS (CPP_Edge)
This is simply the last value of CumulativeProfit% curve divided by the number of trades. It shows you the historical edge you are given by the signals. The higher the edge, the better the signals.
If the last value of CumulativeProfit% is say 5 and the number of trades is 100 then the edge of the signals is 0.05 (or 5%). This means that – on average – the signals gave you a 5% edge every time you followed them. Assuming you have used a long history of the trading instrument in various market conditions and the signals generated many trades this gives you an estimate of what you can expect to gain by following the signals. An edge of 0.05 (or 5%) means that if you always invest 100 000 Euro in the trades generated by the signals, you expect to get (on average) 5 000 Euro from each one of them.
MAXIMUM DRAWDOWN (CPP_MaxDD)
The Maximum Drawdown (or MaxDD for short) is the largest peak-to-trough distance in the CumulativeProfit% curve. The lower the MaxDD, the better the signals. Again, assuming that you have used a long history of the trading instrument and the signals generated many trades the MaxDD practically shows you the least you should expect to lose at some point following the signals.
If for example MaxDD is 5 then this means that if you planned to invest 100 000 Euro in the trades generated by the signals and you started following the signals at the worst possible time in the CumulativeProfit% curve then you should have 600 000 Euro ready because you would have to experience a loss of 500 000 Euro and you would also need an extra 100 000 to follow the next signal.
PROFIT TO MAXDD RATIO (CPP_ProfitToMaxDD)
This is simply the last value of CumulativeProfit% divided by the MaxDD. The higher this ratio, the better the signals.
LONGEST DRAWDOWN (CPP_MaxRecoveryBars)
This is the highest number of consecutive bars the underwater equity of CumulativeProfit% was below zero. The smaller this number, the better the signals.
A MODIFIED SHARPE RATIO (CPP_ModSharpe)
This is a modified version of the classic Sharpe Ratio so the higher it is, the better the signals. It requires a period parameter (namely: SharpeAndSortinoPeriod) which is a positive integer and can be changed via the Indicator properties. The default value for the SharpeAndSortinoPeriod is 21¹. The short formula for the modified Sharpe Ratio is:
¹ Depending on the chart you apply the CumulativeProfit% indicator you can change the SharpeAndSortinoPeriod parameter (that is, the k) to represent annual, monthly, weekly or whatever period you wish. For example, if you are interested in the annual Sharpe in a daily chart then you should set the parameter to 252 since a year has approximately 252 trading days. If the chart is weekly then you should set this parameter to 52 (a year has approximately 52 weeks).
A MODIFIED SORTINO TYPE RATIO (CPP_ModSortino)
This is a modified version of the Sortino Ratio so the higher it is, the better the signals. Like the modified Sharpe Ratio it depends on the SharpeAndSortinoPeriod parameter. Both the modified Sortino and the modified Sharpe ratios are reward/risk metrics. Their difference is that the modified Sharpe regards risk as both upward and downward volatility of performance whereas Sortino regards risk as only downward volatility of performance (see our Algorithmic Trading Tips 16).
PRACTICAL EXAMPLE: DEFAULT EQUITY CURVE VERSUS CUMULATIVEPROFIT% CURVE.
Now we come to a practical example. Figure 1 shows (next page) the Akamai share on a daily chart with the trading strategy “Bollinger Band Entry” applied. In addition to the conventional equity curve (middle) the CumulativeProfit% curve is displayed (bottom). The SharpeAndSortinoPeriod parameter is 21 and the ShowIndividualStatsInPortfolio parameter is set to ‘False’.
When the price of the trading instrument has gone from very low levels to very high ones (or vise-versa) the differences in the Tradesignal‘s default equity curve and the CumulativeProfit% curve are noticeable:
- The price of Akamai Technologies was close to $300 near the beginning of 2000 and ended up close to $0.5 during the fall of 2002.
- The default equity curve (middle sub chart) calculates profits assuming buying/selling the same number of shares all the time. Due to the low absolute price level there is very little change despite the strong upmove during 2003 The equity curve downgrades the performance of the signals after 2002.
- The CumulativeProfit% on the other hand clearly depicts that the signals of the strategy had a superb performance in 2003. The equity curve now reflects the real quality of the trading signals.
The default equity curve shows the combined performance of the trading strategy, while the CumulativeProfit% curve reflects the performance of the trading signals themselves.