The Squid Ratio is a simple method for assessing the effectiveness of trading strategies

Evaluating the effectiveness of a particular trading strategy, advisor, investment in a PAMM account, or hedge fund is one of the most complex processes for making correct and rational decisions.

You'll agree that relying solely on a trader's profitability chart when choosing a PAMM account is a blind gamble, where the risk of losing everything constantly haunts the investor, since we can't evaluate the effectiveness of the account manager's methodology.

The same situation applies to the selection of automated trading experts, where data on profitability and drawdown can only be obtained from history. 

In fact, to evaluate the effectiveness of a particular trading strategy, the well-known Kalmar coefficient was invented. Many investors believe that it solves rather complex problems when choosing an investment object.

The Kalmar ratio was first introduced in one of the most renowned stock market magazines, Futures, by Terry Young, author of a column on asset management and hedge fund investing. This indicator is based on a concept well-known to traders: drawdown.

So, before we delve into the Kalmar formula in more detail and conduct a full analysis of it, let's get acquainted in detail with the concept of "drawdown," without which it is simply impossible to carry out calculations.

Drawdown and its types

It's no secret that real trading is simply impossible without drawdowns and so-called losing streaks. You'll agree that trading is a long series of trades, with both profitable and losing trades always occurring, but the key is that the overall number of winning trades always outweighs the losing ones. In fact, drawdowns are always present in trading, and traders differentiate between fixed and ongoing drawdowns.

A fixed drawdown occurs when a loss is fixed. For example, you have a capital of $100 and lose $10 due to an unsuccessful trade. $10 is 10 percent of your capital, and therefore your fixed drawdown is 10 percent.

Current drawdown is the drawdown on your deposit when you open a trade, as well as the amount you maintain if the trade is unprofitable. Current drawdown is always present in your account, because when you open a position using leverage, you immediately pay the margin and spread, which leads to a negative balance.

Analyzing the current drawdown is much more important than analyzing the fixed drawdown, as many traders don't use stop orders and open multiple positions, waiting out or averaging losses. However, the current drawdown reflects the actual account situation. Although the manager's account balance chart remains unchanged, the amount of funds available for management decreases, which can lead to a loss of the deposit at any moment.

In addition to the two types of drawdown listed above, there is also the concept of maximum drawdown. The maximum drawdown value is derived from the current drawdown and represents the maximum loss of funds relative to the profit on open orders. The maximum drawdown is used as the basis for calculating the Kalmar coefficient.

Calculation of the Kalmar coefficient

The Kalmar coefficient is calculated using only two values: the compounded return, taking into account reinvestment over a given period of time, divided by the maximum recorded drawdown. This coefficient should be used when analyzing the profitability of a PAMM account or advisor over a long period of time, which should be at least one year.

So, why such a long period? The formula is based on what's known as compound interest, which accumulates over a long period of trading. The duration of stable trading is one of the key indicators of an account's viability.

Let's look at a more visual example of calculating the coefficient. Let's say a trader demonstrated a total return of 90 percent per annum over the course of a year, taking into account reinvestment. Because the trader adhered to risk management, the maximum recorded drawdown was only 10 percent.

So, according to the formula, 90/10 = 9. It's important to remember that the coefficient can also be negative, which indicates the complete ineffectiveness of the trader's chosen trading strategy.

The Kalmar Coefficient's Flaw That Everyone Is Keeping Silent About

In conclusion, I'd like to note that the Kalmar coefficient is one of the most popular indicators of the effectiveness of a managing trader's or advisor's . However, this indicator has one drawback: it is not time-based.

For example, if an account has been languishing with zero profitability for a year, and in the last month the trader accidentally hit a good wave and earned 40 percent of the deposit, then the Kalmar coefficient may indicate a good manager's tactics, although in reality the strategy is unprofitable.

It is also important to remember that the minimum value of the coefficient should not be less than 3, since otherwise the strategy is not viable, and the drawdown and risks are much higher than the profit.