How to Fairly Evaluate a Quantitative Trading System?

Although our product differs significantly from traditional quantitative strategies, we are essentially still a quantitative strategy and therefore subject to traditional evaluation metrics for quantitative strategies. In fact, you can use this framework to evaluate any investment opportunity yourself, as this has been the cornerstone of strategy evaluation in the financial field for hundreds of years.

There are 7 indicators for evaluating a quantitative system, divided into three categories:

1. Profitability

• Annualized Return: Measures the strategy's performance over a year, reflecting its profitability. Most funds in the market use annualized returns to compare with each other, so this indicator is clear at a glance - the higher, the better.
• Sharpe Ratio: Risk-adjusted return, showing the return per unit of risk. It's an important indicator for measuring strategy strength, not just luck.
• Number of Trades: The trading frequency of the strategy, reflecting its activity level and market participation.

2. Risk Control

• Maximum Drawdown (MDD): Represents the maximum potential loss from peak to trough, crucial for understanding downside risk. An excellent strategy needs resilience and shouldn't collapse even in the worst market conditions. Generally speaking, keeping it within 10% is considered an excellent strategy.
• Expected Shortfall (Tail Risk): Quantifies expected losses in tail events, providing insights into extreme risks. It measures the maximum loss a strategy might face when black swan events occur. The lower this indicator, the better - it should typically not exceed 20%.

3. Scalability

• Strategy Capacity: Determines the amount of capital a strategy can manage without degrading performance, crucial for evaluating scalability. This indicator is often overlooked but very important. If a strategy has small capacity, it may not be able to maintain promised returns when the fund size exceeds a certain amount.
• Market Adaptability: Whether the strategy performs stably in different market environments (bull markets, bear markets, sideways markets). An excellent strategy should maintain consistency under various market conditions.

In-depth Analysis of Key Indicators

Below, let's deeply understand these key indicators:

Annualized Return

Annualized return is the most intuitive indicator for measuring strategy profitability. It reflects the strategy's return performance over a year - of course, the higher, the better. However, it's important to note that annualized return alone cannot make any judgment; it must be combined with other indicators for comprehensive evaluation.

Sharpe Ratio

The Sharpe ratio is an important indicator for measuring risk-adjusted returns of a strategy. Its calculation formula is:

Sharpe Ratio = (Average Return - Risk-free Rate) / Standard Deviation of Returns

It has two key points:

• Average Return: Reflects the return level of each trade - of course, the higher, the better.
• Standard Deviation of Returns: Reflects the volatility of returns. The larger the standard deviation, the greater the return volatility and the higher the risk.

The important significance of the Sharpe ratio is that it can eliminate strategies that achieve high returns due to luck. Generally speaking:
A Sharpe ratio above 1 is already good; above 2 can be considered excellent; above 3 is outstanding.

Number of Trades

It's important to note that a high Sharpe ratio doesn't necessarily mean the strategy is excellent; it must also have a certain number of trades and market adaptability.
Generally speaking, at least 50 independent trades are needed, and these trades should be distributed across different market conditions (bull markets, bear markets, sideways markets) to have statistical significance.

Maximum Drawdown

Maximum drawdown is an important indicator for measuring a strategy's risk tolerance. It reflects the maximum loss a strategy might face during return retracement. An excellent strategy needs to maintain resilience during cyclical market fluctuations, with maximum drawdown controlled within 10%. Drawdowns exceeding 20% might cause investor psychological collapse, leading to redemption waves and fund collapse.

Tail Risk

Tail risk measures the maximum loss a strategy might face when black swan events occur. It's a quantitative assessment of extreme risks. The lower this indicator, the better - it should typically not exceed 20%. Note the difference between this and maximum drawdown - it refers to strategy performance after the worst-case scenario in a power-law distribution occurs.

Strategy Capacity

Strategy capacity refers to the maximum amount of funds a strategy can manage without reducing performance. This indicator is very important but often overlooked. If a strategy has small capacity, it may not be able to maintain promised returns when the fund size exceeds a certain amount. Therefore, investors need to understand the strategy's profit sources: does it rely on arbitrage in a few opportunities, or can it participate in bulk asset trading? You certainly don't want to invest in a "small fish" strategy but rather a "great white shark" strategy.

Summary

If you encounter someone showing off their trading performance on social media again, you can use the framework in this article to evaluate their strategy. An excellent quantitative strategy must simultaneously satisfy the following 7 principles:

• High annualized return;
• High Sharpe ratio;
• Sufficient number of trades;
• Small maximum drawdown;
• Low tail risk;
• Large strategy capacity;
• Strong market adaptability.

If the other party doesn't provide complete information, their boasting is meaningless. Remember, all investment traps are due to not simultaneously satisfying the above 7 principles.