There are a multitude of metrics to gauge how "good" or "bad" your strategy is. While numerous attempts have been made to create some universally accepted gold standard to rate strategies and performance, and while many traders search for that standard like its El Dorado, the reality is that there are as many analyzers as there are different notions of what constitutes a good trade. Pick ones that measure performance relative to your trading style and risk tolerances. Here's a brief summary of the ones calculated at DimeChimp...
Sharpe Ratio
The Sharpe ratio is one of the most commonly used measures of a portfolio's risk. It takes a portfolio/strategy's excess returns (returns greater than some benchmark like a risk-free rate of return) and divides it by the standard deviation of those returns. What it tells us is how volatile our returns are.
Let's say, for example, that a portfolio returns 10% over the year, but that return comprises of the exact same daily returns throughout the year to eventually add up to 10%...a model of consistency. Compare this portfolio with one which returns 10% one day, then -10% the next and happens to end the year at 10%. Because the volatility of the returns of the first portfolio is much lower than of the second, its Sharpe ratio will be much higher. Sharpe is a great way to compare portfolios against each other with regards to their volatility.
Sharpe ratios >1.0 are widely considered "good," >2.0 are "very good" and >3.0 are "super duper," yes, a technical financial term. Interpret that however you want...but they're better as comparative measures.
Calmar Ratio
The Calmar ratio measures a portfolio's performance (annualized rate of return) compared to its maximum drawdown. What's a drawdown? Every trader knows that feeling of seeing their portfolio down and comparing it to the highest point it's been. A drawdown is the differential between a portfolio value's peak and trough over a certain time, namely, the portfolio's worst loss...and is an important factor in determining whether you're trading within your pain and capital threshold.
Calmar ratios <1.0 indicate that a portfolios return doesn't exceed its maximum drawdown...not great. Anything between 1.0 and 3.0 is still considered "risky" while anything above 3.0 is considered a sound portfolio. While comparing a portfolio to its maximum drawdown has value, it doesn't consider the volatility of those returns like the Sharpe ratio does. If you're a Nervous Nelly and hate seeing big pnl swings, Calmar might not be as useful to you as to traders willing to ride the turbulence as long as the boat doesn't sink.
System Quality Number (SQN)
SQN measures the relationship between profit and risk on a per trade, or "operation" basis. Basically, it's a gauge of whether your system performs expectedly and consistently every time you trade or whether each trade is a wild swing in the dark. Longevity in this game typically requires consistency not just in year-over-year performance but also every time you take a risk. The higher your consistency, the higher the "quality" of your system.
SQN is calculated by scoring each trade you make by its return versus the typical risk you take, then getting an average of these scores. It then compares this average to the standard deviation of these scores. The higher the deviations, the lower the score, and vice versa. Of course, the number of trades you make matters in showing consistency, which is also taken into consideration in the calculation. A higher number of trades would give a better indication of the quality of a system than a lower number.
SQN rankings go as follows: <1.00 - hard to trade, 1.01-2.00 - average, 2.01-3.00 - good, 3.01-5.00 - excellent, 5.01-7.00 - superb, >7.00 - "holy grail"
Are the ratings as arbitrary as the descriptions? Perhaps. Again, it's one data piece of the proverbial puzzle and should be taken as such, and is a good measure of relative system quality if you have multiple systems to choose from.
Variability Weighted Return (VWR)
VWR is a metric that attempts to remedy the perceived drawbacks of the Sharpe ratio. While the Sharpe ratio rates our systems considering the variability of our returns, it doesn't consider its scale. Two systems can have the same Sharpe while one of those systems has half of the returns and also half of the standard deviation of returns. Further, variance in returns isn't necessarily a bad thing although only considering the Sharpe would indicate so. Some systems expect setups with periods of lower pnl followed by big spikes up (consider a system of buying out-of-the-money options - we expect to lose money on a day-to-day basis through time decay, but expect to make it back on big move days). Taking and combining these two factors...sometimes systems have more variability but have higher returns which are worth it. It's not inherently a bad idea to trade a more volatile system if the returns merit it.
VWR assuages these downfalls by normalizing returns, and instead of dividing it by any standard deviation (dividing by things which can get close to zero can be pretty hairy), multiplies it by a multiplier considering an investors tolerance for price variance...it uses differentials of prices in a system as a weighting factor instead of standard deviation of returns.
Calculating the VWR requires choosing a maximum allowed deviation of price differentials as well as a preferred weighting curve. As such, it's not possible to give a bracketed gauge for values which constitute a "good" or "bad" system. That said, beating dead horses is great, so use it as a comparative operator to rate systems relative to each other.
