Two Methods of Performance Analysis
The conventional approach to performance analysis has become extremely complex, involving numerous mathematical and statistical methods and ratios.
The most common is the Sharpe Ratio.
The Sharpe RatioThis popular performance ratio was developed by Nobel laureate William F. Sharpe. The Sharpe Ratio is typically calculated by subtracting a risk-free investment rate, such as the 10-year U.S. Treasury bond, from the rate of return for an investment or portfolio, and then dividing the result by the standard deviation of the investment or portfolio return.
Market EnvironmentsThis author uses market environments (ME) to analyze performance.
ME divides all markets into functions of directional movement (DM) and volatility (V). If each function is rated on a scale of 1 to 10 from very low to very high, it gives a matrix of 100 market environments from (1,1) to (10,10). (See Table below.) Look for money managers who have done well in a broad spectrum of MEs instead of just a scattered few. Performance -- good or bad -- that occurs in a mostly contiguous area of the matrix (clusters) can tell you much about the manager's trading methods.
[caption id="attachment_13328" align="aligncenter" width="515"] A 10 × 10 DP/V ME Matrix[/caption]
Tip: A short track record with a broad ME sample may be better than a long track record with hot and cold ME clusters. See Tools for Traders, for more on ME applications to trading.
Pac Man programs take a different tack. They do not attempt to work well in all MEs or tweak the program to emphasize naturally strong ones and deemphasize naturally weak ones. Rather, they define MEs with very specific DM and V values in advance. When a currency pair enters one of these price-time areas -- they strike. Pac Man programs execute a hedge order and attempt to gobble as much price movement in both directions as long as they are in the defined parameters. Neat!
By Michael Duane Archer