You are probably familiar with the Sharpe Ratio, developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance for a portfolio. Portfolios with higher Sharpe Ratios deliver better risk-adjusted returns, when risk is measured by the volatility of returns from the portfolio over time. When we backtest portfolio strategies, we include the Sharpe Ratio to help in selecting strategies with an appropriate balance between return and risk. Of course, “appropriate” is in the eye of the trader, but higher Sharpe Ratios are better, if other portfolio metrics are acceptable across the alternatives.
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Suppose that a trader’s plan is not to trade a systematic portfolio, but instead to select individual trades from among multiple strategies on a particular day given his or her perception of current market conditions and opportunities. Because such discretionary factors may be hard to quantify, it is generally difficult to test the effects of such choices on total return and risk over historical timeframes.
But, balancing return and risk are still important considerations. Suppose the trader’s assessment of market conditions narrows his alternatives to two particular strategies on a given day. How does he or she choose between signals from the two alternatives?
To help with that choice, Connors Research has adopted a measure of risk-adjusted return per trade which uses concepts similar to those incorporated in the Sharpe Ratio, but translated to individual trades. We call this measure “Individual Trade Quality”, or ITQ. So, with other considerations being roughly equivalent, the trader would choose signals from the system with higher Individual Trade Quality.
Individual Trade Quality is calculated according to this formula:
ITQ = (Average % Profit/Loss per Trade)
/ (Standard Deviation of % Profit/Loss per Trade)
The Average and Standard Deviation should come from historical backtesting over a wide range of conditions. Using only a trader’s actual track record can be misleading, because that record doesn’t account for the trades that the trader bypassed.
Perhaps the easiest way to appreciate the value of ITQ is to consider two strategies whose historical Average % Profit/Loss per Trade metrics are essentially identical. If, however, one of the two has a noticeably higher Individual Trade Quality, then it will offer considerably more consistent results, i.e., its returns are much more likely to fall near the anticipated Average.
As with Sharpe Ratios in the context of portfolios, higher ITQs are generally preferable to lower ITQs when selecting individual trades from alternative strategies along discretionary lines, if other factors are roughly equivalent.
We have been using ITQ internally for some time now. However, you will begin to see this metric more frequently in our future presentations and publications.