Three little letters. And yet so important. RAP is Risk-Adjusted Performance. And in the world of trading, it IS the holy grail.
In terms of winning long-term, it doesn't just matter that you have winners, it matters how much you put at risk to rack up those winners. Because inevitably, there will be losses. And a big enough loss can wipe you out.
In the words of John Mack, former CEO of Morgan Stanley:
“One of the critical criteria I use in judging my traders is their ability to take a loss. If they can’t take a loss, they can’t trade.”
This all gets back to our innate bias to have a strong impulse for loss aversion. If you want to be a good trader, you eventually have to figure out how to get a handle on this. (If you want to learn more about these fascinating topics I've listed some books here that I think cover them thoroughly and well.)
For me, the answer was to take my psychology out of the equation by using an automated trading strategy (ATS). One of the beauties of an ATS is that it is inherently testable. Because you control the input parameters, you can test and reproduce results under a number of market conditions with ease. What this means is that you can, with some certainty, determine how your system will perform in various future states. And if you want a winning system, you have to make sure that the risk you take is justified by the wins you make.
I'm going to get a little heavy into the academic concepts for a bit, but if you hang with me, I think you'll find the payoff worth it. In probability theory, there's this notion of expected value (EV). It simply means, if you traded a particular system a huge number of times, on average, what would you expect to make on each trade. If it's negative, stop now, do not pass go. If it's positive, it's encouraging, but you shouldn't stop your analysis just yet. You see, not all expected values are created equal. There are some other parameters that come into play. For example, you could consider:
Many platforms readily provide information on the first. You can look at two different systems and compare the number of trades and average EV of those trades over the same time frame and get a handle on which system has the greater frequency. For the second one, you have only to determine what your clearinghouse requires for initial margins and compare the average EV of two systems on that basis. The final point I find best addressed by this concept of Risk-Adjusted Performance, or RAP. This is the piece that sets winning traders apart from losing ones in the long run. They've done studies that prove it. (If you'd like to see some of the papers that discuss this, contact us here.)
You can get to RAP by looking at two numbers -- daily average expected returns and value-at-risk (VaR). Value-at-risk rank orders the maximum adverse excursion of every trade over a given time period and takes the 95th percentile. This tells you that 95% of the time, you will risk this much or less on each trade. Over the long haul, the guys who study this for a living have found that if you have Risk-Adjusted Performance above 0.35, you're doing great and the probability that your account will not just survive but thrive is high. You're setting yourself up for success in the long run.
So, my recommendation to you is that for any trading system you're considering putting your money behind, be sure to understand the RAP. It'll let help you compare systems and pick only the best. As with all things in life, decisions of this magnitude are multi-faceted and you can't make a determination on one number alone. But, as part of a balanced analysis of some of the other factors I mentioned above, you'll be on the right path to picking a system that works for you.
As always, if you'd like to discuss anything I've mentioned here in more detail, please don't hesitate to contact us directly. Until then...
HAPPY TRADING TRADERS!!
frequency of the trade, i.e. if one system has an EV of $1,000 every five days and another has an EV of $1,000 every two days, which would you prefer?
size of the expected value with respect to the number of lots you can trade. If one system delivers an EV of $1,000 and requires initial margin of $500 and another delivers the same EV but requires an initial margin of $2,000, which works better for you?
size of the EV with respect to its overall volatility. This is important because it helps you determine if you can withstand the inevitable drawdowns that come with trading in any market.