Measuring your EDGE in algorithmic trading

There are a lot of statistics which can be used to describe algorithmic trading strategies returns. Risk reward ratio, profit factor, Sharpe ratio, standard deviation of returns… These are great statistics, but they miss an important factor: Are your returns statistically significant or just a collection of lucky noise. The EDGE statistic might me the answer to this question.

 

Statistics in trading:

If the returns of your trading strategy are positive with in-sample and out-of-sample data this is a first sign that you are on the right path. The next step would be to have a look at the risk-reward ratio of your trading to get an impression if the strategy might be useful in a real world environment.

Assuming that your average yearly returns are about twice as big as the worst case historic draw down you can even be more confident that your strategy is useful. But there is still one thing to check before you can be sure that you are not just seeing a curve fit bullshit strategy. The standard deviation of the daily returns vs. your average daily return.

Defining EDGE

Assume your strategy made 250$ over the last year. This averages to about 1$ per day. This 1$ is a good or bad return, depending on the standard deviation of your equity line. If the standard deviation of your equity is 2$, then the 1$ average return strategy would be a bad strategy, as your average returns are way too small in respect to the volatility of your equity. If your volatility of your return curve would just be 50ct and you still make 1$ per day on average, your strategy would be ingenious.

Edge is the ratio of your average returns vs the volatility of your equity line. To be on the safe side,  your average return should be about 5% above the 90% confidence interval of your equity line volatility.

The left chart is a strategy trading an one month RBOB time spread, the right chart shows the same strategy trading German power. Rbob has got an edge of 3%, German power has got an edge of 5%.

If I would have to select which market I want to trade with this sample strategy, I surely would select German power over the rbob time spread. Both curves have their up and downs, but rbob is heavily relying on a lucky trade in September. This lead to a high standard deviation of the equity line , giving you a low edge reading.

Conclusion

Observing the ration between your average daily returns vs. the volatility of your equity curve can give you some valuable insights in the quality of your strategy. If it just called a few lucky trades in history, it will also show a high volatility in returns. And this you most probably want to avoid when turning to algorithmic trading. It`s not just the absolute profit at the end of the year, it is also the path you took to get to this number. The smoother, the better!

[Equilla / Easy Language code for EDGE indicator]