By: Nikos Akkizidis
There are at least three components to successful trading:
- The trader’s psychological makeup,
- The trading system’s edge, and –
- Strict money management
As far as the trader’s psychological makeup is concerned, it requires a more complex analysis that is directly related to the trading system’s edge and strict money management a trader follows. This article will focus on quality and significant indicators measuring the trading system’s edge and strict money management.
The trading system’s edge is defined by five different measures that act complementary to each other.
- The monthly compounded return of the trading system edge is followed by a trader. It measures the level of returns that the trading system can yield over time.
- The maximum return of the trading system’s edge has been achieved in the most successful month. And if this performance represents the maximum potential performance of the trading system edge.
- The Sharpe Ratio measure of returns per unit, of standard deviation. This is a measure of returns per unit of risk. It allows comparing returns from trading systems with very different risk characteristics.
- The skewness of returns. Skewness measures the degree of return asymmetry in terms of the probability distribution around the mean. In fact, a positive number indicates that the trading system generates returns higher than the mean more often.
- The Kurtosis of returns. The Kurtosis measures how returns are packed around the mean relative to a normal distribution. A positive number tells you that there is a higher probability of finding returns near the mean than a normal distribution.
- Skewness and kurtosis are rather technical and give you an idea of how capable a trading system has generated more significant returns with a high degree of probability. Skewness is a measure of symmetry, a lack of symmetry, while Kurtosis measures whether the data are tailed relative to a normal distribution.
The quality of money management of the trading system is also defined by five different measures:
- The standard deviation of returns consistency with which the trading systems achieve their returns. The standard deviation of returns gives an indication of the probability of potentially high returns or large drawdowns relative to the trading system average monthly return.
- Maximum monthly drawdown of the potential loss magnitude. This is an indication to control risk and to find whether the trading system indeed trades at optimal levels.
- Months of recovery from worst drawdown. Trading systems with good money management will recover from the worst drawdown when other parameters remain equal, quicker than programs with poor money management.
- The standard deviation of times to recover from drawdown. This indicator measures the consistency with which trading systems come out of drawdowns.
- Time to recover from the worst drawdown as a percentage of the trading system life. It indicates how much of a trading system life was spent recovering from the worst drawdown.
The measures mentioned above can theoretically show that a trading system with good money management can recover from drawdowns much faster than a trading system with poor money management. This is important as it means that it is allowed to compare trading systems with different characteristics that have the same edge. The one with better money management will recover from drawdowns faster.
It is recommended that the results of the study be displayed in a table as presented below so that both the trading system’s edge quality and the money management quality can be compared for different trading systems.
Successful traders have a larger edge and much better money management than unsuccessful traders. However, the results do not tell which one of the above variables might be more important in explaining the successful trading system. The explanation of the variables that measure the successful trading system is linked to the trader’s psychological makeup.
Studies have proved that the smaller edge is not the cause of the trading system’s failure. The trading system’s success can be explained almost exclusively by its meaningful money management practices. If we want to give meaning to the edge, the importance of money management should be focused more on as this will improve the psychology of traders and confirm the success of a trading system.