How to Know if Your Trading Strategy is Actually Good?

0:00At this point of the tutorial series, you should understand your terminology.

0:04You should understand what is a trading strategy and how a trading strategy is composed of conditions that execute actions in the stock market.

0:16But you're still probably wondering this one thing: how can I create an actually good trading strategy?

0:25Or more specifically, what makes a trading strategy good, and what makes a trading strategy bad? Let's talk about it in this video.

0:38A good trading strategy isn't just a trading strategy that makes money.

0:43It's not just a trading strategy that's profitable over some period of time, because you have to consider your alternative investment ideas.

0:55If you weren't learning algorithmic trading, then the smartest thing to do with your money, at least according to the vast majority of financial advisors, is to invest your money in the S&P 500.

1:10Over the past 100 years, the S&P 500 has averaged around 10% per year.

1:19And if you're building a trading strategy, your goal is to outperform this 10% per year. And why is that?

1:30Because creating an algorithmic trading strategy is a lot of work. It requires time researching, time learning terminology, time that can be spent doing literally anything else.

1:44So if you're not able to build a trading strategy that outperforms this 10%, then you might as well not learn algorithmic trading at all.

1:53You might as well invest all your money in the S&P 500, just buy that one ETF and do nothing else. So your goal is always to try to outperform the broader market.

2:09Now, a trading strategy is good if at least two of these things are true.

2:15Number one is if the trading strategy tends to outperform the S&P 500 in terms of raw gain.

2:24If the S&P 500 gained 10% this year, you want your trading strategy to gain at least 15%.

2:32You want to get a little bit more to account for things like slippage, taxes, anything else that could decrease your final gains.

2:42But if you're a more advanced investor, it's not just enough for your trading strategy to outperform the S&P 500 in terms of raw gains, right?

2:53You want to outperform the S&P 500 taking into account how much riskier this strategy is. In trading, we have terms for these concepts.

3:07One of these terms is the Sharpe ratio.

3:10The Sharpe ratio is a ratio that gives us our risk-adjusted returns, how much returns our strategy has given how volatile our strategy is during the period.

3:23There's plenty of other terminology similar to Sharpe ratio that can tell you similar things.

3:29For example, another metric we have is the Sortino ratio, which gives us how much return our strategy has given how risky it was during volatile down periods. It's a correction of the Sharpe ratio that doesn't penalize it for having volatile moves up, but does penalize it for having volatile movements down.

3:55There are other ratios too, the Calmar ratio or the Ulcer Performance Index, and these ratios give us some idea of how our trading strategy is performing.

4:07Finally, we have other metrics such as drawdown, which is one of the most important psychological metrics for a trading strategy.

4:18A strategy's drawdown is simply the percent loss from the highest point of the strategy to the lowest point of the strategy.

4:27If a strategy has a max drawdown of 50%, that means from top to bottom you saw your portfolio losing half of its entire value.

4:38This is important because, just psychologically speaking, having large losses hurts most people.

4:46Most people are loss averse, so a very large drawdown might cause them to lose faith in their strategy and make them make poor decisions, like selling earlier or becoming more aggressive when they shouldn't.

5:02These metrics help us determine how good a trading strategy is.

5:07So if your trading strategy has a greater return, a lower drawdown, and a better risk-adjusted return than the broader market, then that's what is considered a good trading strategy.

5:24In this next module, I'm gonna be talking about backtesting, which is a way of how you can test your trading strategy on past historical data.