For anyone who is an avid golfer you have probably entered your scores and use a service to give you your handicap index. For those who don't golf, essentially a way to index your golf scores taking into account how tough the courses are etc etc.
With trading quite often I'm asked what % I make annually or how much money I make. This really isn't in my opinion the best gauge of how a trader is doing.
You see, whenever I see one of those trading contests on TV where they applaud someone making 100% in month, what they don't outline is what their trading plan was. Did they go all in and buy millions of penny stocks and get lucky?
Or if say a trader has $100k and they made $20k on the year-it shows them as +20%. But what if they only traded $20k of that stake and thus their trades yielded 100%? Didn't they have a better year than the trader who put the entire $100k into positions?
One thing I've been working on is creating that same type of handicap index but for traders.
First defining the terms
--how many trades are in the sample
--what is the winning %
--add up all of the winning trade amounts-what is the avg
--add up all losers-what is the average.
--what is the ratio (if my win trade amount average is $500 and my lose trade amount average is $250, then you have a postive 2-1 ratio)
10 trades made
Average amount of winning trades $1000
Average amount of losing trades $500
Dividing the win avg/loss avg= 2.0
Lets say this traders winning percentage is 40%
Take 40x2=80 (note since the avg win/loss is + then you simply use the winning % in the calculation)
Index Score of 80
Avg of winners $1000
Avg of losses $1000
since they are the same 1000/1000=1
Index Score of 60
avg winners $1000
avg loser $2000
losers outdo winners 2/1 ratio
Since its a negative win amount avg to loss amount avg.
Here is where we take 100- the winning% and then multiply by the loss/win amount ratio and create a negative index score.
so 100-60=40 40x2=80.
Since avg loss outdid avg gains this becomes a negative index of -80
Now a couple points on this- just like 3 rounds of golf where we suddenly find our putting stroke and shoot in the eighties doesn't mean that we will always be in the 80's. This is designed to reward behaviors just as much as results so a larger sample size yields better evaluation.
Another aspect is that with this, traders can see how they are trending.
One other thing- playing with the numbers I can create a 10% winning percentage with say all losers of $1000 and one winner of $10,000 over 10 trades and that would have a score of +100 which is higher than trader B. You might say Trader B example wound up with more cash but remember, this is really set up to reward a traders average winners being over time larger and hopefully much larger than losers.
What we learn from this is that the greater the ratio, the less right we have to be. The less our wins are greater than our losses, the more we have to be right.
By the way, if there are any poker players out there-this probably resonates with you as well.
Hope this was helpfull, interesting, entertaining.