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Trading systems offer a way to trade forex markets free from emotion and distraction and can be easily utilised these days through various back testing platforms such as those available from MetaTrader and other vendors. MetaTrader also has a large community of users who you can ask for help and there are plenty of other systems (called expert advisors) that can be downloaded and tested for free.

Once you have a system, however, it is important to be able to analyse it properly so you can assess its ability to make future gains. Most of these metrics can be calculated automatically by your trading platform.

Guest post by  FXTM

Look at the equity curve

The fastest and easiest way to measure a trading system is to eyeball its equity curve. If the equity line is erratic and looks like a rocky mountain face then this is probably an erratic system. The system may use any number of indicators but in truth, the results may be more or less random.

However, if the equity line is near perfectly straight and goes up almost in a straight line, then this system is probably too good to be true. Take a closer look to make sure it is not curve fit or references future data. And make sure it doesn’t use an unsustainable position sizing strategy such as Martingale.

The best equity curve should be a fairly smooth upward sloping line that works over different market conditions.

CAR

CAR stands for compounded annual return and is delivered as a percent. It shows how much the portfolio returns per year. A high CAR sure looks nice but it is not always the best metric to measure system performance since it does not take into account risk at all.

CAR/MDD

CAR/MDD is thus a better metric to measure system performance as it analyses percentage annual growth divided by the maximum drawdown. (Maximum drawdown refers to the largest peak to peak decline in portfolio equity).

Essentially, the higher the CAR/MDD score, the smoother the equity curve and the better the system.

Profit factor

Profit factor can be a good measure, since it divides the profit of winners by the loss of losers. It’s a quick way to look at the chances of your system being profitable.

Risk-reward ratio

Risk-reward ratio can be measured by dividing the slope of the equity line by the standard error of the equity line. It’s an important metric to be able to calculate the optimum position sizing for a system.

Sharpe ratio

Sharpe is a popular metric that was developed by William Sharpe in 1966. It describes how much return you receive from the added volatility for holding a trade. Basically, the higher the sharpe ratio the better the system. However, Sharpe ratio has come under criticism for not recognising that upward volatility is more desirable than downward volatility.

K-Ratio

K-Ratio is another popular measure and examines the consistency of an asset’s return over time. It generally does a good job of measuring risk versus return and involves running a linear regression on the log-VAMI curve.