A Measure of the Trading Model Performance with a Risk Component
Posted: 25 Dec 1998
Date Written: June 1994
The purpose of this paper is to suggest a new measure of trading model performance which accounts for the following requirements: 1. a high total return; 2. a smooth behavior around a straight line; 3. a small clustering of losses; 4. no bias towards low-frequency trading models. It is important to define a value that describes the performance well to minimize the risk of over-fitting in the in-sample period and to be able to compare different trading models with each other. In the first section of the paper, we discuss the Sharpe index, a measure frequently used to evaluate portfolio models. We show that it does not fulfill all the above requirements. In the second section, we propose a new measure based on a risk averse trading profile and the utility function formalism of Keeney and Raiffa (1976). This measure is numerically more stable than the Sharpe index and exhibits fewer deficiencies. In the third section, this measure is extended to a multi-horizon measure in order to be able to account for the clustering of losses in the return curve. In the same section, some numerical aspects of the computation of this variable are discussed.
JEL Classification: G11
Suggested Citation: Suggested Citation