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Trading as a Business:
The Science of Strategy Evaluation
By Charlie Wright
The science of strategy evaluation has two basic parts to it. The first part is the evaluation of the financial aspects of the strategy. How do we measure profitability? Is a particular trading strategy a better place to put your money than alternative investments or businesses?
The second part of strategy evaluation is more personal in nature. The strategy must be evaluated in light of the person who will be doing the actual trading.
This is what I call statistical evaluation. Does the historical performance make this strategy acceptable to the personality and trading style of the individual trading it? Does this trading strategy have characteristics that will allow the person to trade it effectively and have the discipline to execute it? Will the trading of this strategy provide too much emotional stress? The statistics will tell us.
And finally, it is important to know when your strategy has stopped working.
There are two ways to evaluate a strategy financially. First a strategy may be evaluated on its own merits as compared to alternative forms of investing. That is, the return on invested capital over a period of time. How does the particular trading strategy stack up as compared to T-Bills, common stocks, etc?
Second, a strategy should be evaluated financially on its own merits. This means is it viable as a trading strategy as compared to other trading strategies? Does Strategy A provide a better return than Strategy B?
RISK-FREE RATE OF RETURN
The place to start when contemplating a trading strategy is with the risk-free rate of return. This is the return you would expect to receive on an asset that is virtually risk free. Most analysts use the 90-Day US Treasury Bill rate as the riskfree rate. And while it could be debated as to whether the debt of the US Government is risk free, it is a close as we can come.
The first and most obvious principle is that any strategy must provide a greater return than the 90-Day T-Bill rate, or you would simply be better off just putting your money in T-Bills.
However, you must also assess the return that you will require of the strategy in order to compensate you for the added risk. How much income over and above the T-Bill rate is required to entice you to take your money out of T-Bills and put it into a trading strategy? You should assess the premium that you will require for trading a particular strategy.
As the risk is greater for trading stocks and futures, this premium should be quite large. I have always recommended that for stocks you should at least double the T-Bill return rate, and for futures you should require four times the T-Bill return. If the T-Bill rate is 6%, I would require at least a 12% return per year for stocks and at least 24% per year for futures before I would consider taking my money out of T-Bills and putting it in these markets.
If the current T-Bill rate were 10%, I wouldn’t be interested in a strategy for futures that did not return at least 40% per year. If the historical testing did not indicate that this 40% return was possible, I would keep my money in T-Bills. Ultimately, you must determine your own risk premium. Take some time to think about what you consider to be a reasonable return for your trading efforts. It might not be my four times the T-Bill rate; you might only require three or two times. But if you are not compensated for the increased risk, it is more prudent to place your money elsewhere.
Also note that using my recommended approach permits the required rate of return to change over time in that there have historically been large swings in the T-Bill rate. In times of high inflation, like during the late ‘70s, the T-Bill rate generally rises, thus requiring a higher return for your trading account. In times of low inflation, the T-Bill rate lowers and therefore you would not require as high a return from your commodity or stock trading accounts.
In times of high inflation, the volatility of most stocks, commodities and futures increases, thus providing the opportunity to profit from this increased volatility. You must make sure that that your strategy will provide the necessary return in different financial environments (high or low inflation, recession, etc.).