What you need to know to tell a good Forex strategy from a bad one!
If you want to trade the financial markets, it’s imperative for the long term consistent success, that you have a strategy in place. You’ll be amazed by the number of people who are still trying to find their way in the markets, and they don’t have a trading strategy.
They’re literally risking their hard-earned money with no trading strategy.
Test your strategy
For the sake of this blog, let’s assume that you’ve got a strategy.
To test a mechanic strategy, simply run it through the MT4 Strategy Tester, or use another software like Forex Tester 3 to see how it operates in past data.
In case you’re trading using a discretionary strategy, then you’ll need to scroll back in terms of historical data through the price chart, looking to see how that strategy performed on historical data. When you’re manually back-testing the strategy, logging each tree candle by candle, sometimes it is the best way to evaluate and test a strategy. You get to know its characteristics as you go.
Was it a profitable strategy? Was it a losing one? In order to really know that, you need a number of metrics that we use to evaluate the strategy. Having this data to hand really it is so important when you take the strategy into the live environment.
Understand the metrics
Now, these metrics are quite easy to understand and simple to calculate. When you are evaluating a strategy in your backtest using metrics, you should be looking at the relationship between the metrics with each other, not just a stand-alone metric of its own.
- Win rate/Loss rate. The win rate is the number of wins over the number of trades in that testing period. Of course, the loss rate will be the opposite. It’s the number of losses over the number of trades in that testing period.
- Average win/Average loss. The average win is simply the total dollar profit on the winning trades divided by the number of winning trades. And the average loss will be the cumulative loss of dollars on the loss of trades, divided by the loss of trades.
A strategy with a win rate of 95% is expected to make it 95 times out of a hundred, but every time it wins, the average win could be just $10. That it will give you a profit of $950, after 100 trades. If the average loss is $200, then you’re going to lose $1000 on those five losing trades.
The next two metrics that you should know are:
- The Profit Factor is simply the total dollar profit divided by the total dollars lost. When you are backtesting, you’ll want to see anything over 1.5 on a profit factor because of the vulnerability of back-testing data.
- The Take-Profit Factor, known as the TP ratio, is the average win over the average loss.
Another important metrics is The Expectancy.
- The Expectancy is the win rate multiplied by the average win, divided by the loss rate, which is multiplied by the average loss. This tells you how much you can expect to win with any trade you make.
If you have an expectancy of $15, then you can expect to receive $15 on every trade that you make, including the losses.
- Drawdown is one of the most underrated metrics, but crucial when evaluating where to take that strategy forward.
Imagine you start off with $1000 and your awesome strategy takes you up to $1,200. Then you have the inevitable losing streak and it comes back down at only $700. If you hit some winning trades, you’re back up to $1,100 and on paper, you’ve made 10% on that trade.
But within that, you’ve actually had a drop of $500. So 500 divided by 1200 will give you about 41% drawdown.
Would you be trading a strategy to make 10% with the potential draw down of 40% ? I don’t think so.
- The Consecutive Wins over The Consecutive Losses.
For example, the outcome for these 100 tosses is 50-50 and the win rate is 50%. Even by evaluating that, you don’t know when the wins or losses will come just by looking at the win rate or the loss rate.
So you need to be aware of the maximum consecutive losses and the consecutive wins that you’ve had in the strategy. This is going to be an asset when you finally start trading in a real environment because you’ll be able to see whether it is conforming to your backtest.
A quick summary
It’s worth looking back at some of your past trading records and see if you can figure out your expectancy, your average win-loss ratio, your take profit ratio, and if your strategy is performing the way it should be. It’s all quite simple if you digest it slowly.
I hope you have found this valuable and if you would like to learn more, join me in the Trading Room. I hope to see you there!