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

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

Agree, relying only on the data of a trader’s profitability chart when choosing a PAMM account is a blind game, where the risk of losing everything constantly haunts the investor, since we cannot evaluate the effectiveness of the methodology used by the account manager.

The same situation is with the choice of automatic trading experts, where data on profitability and drawdown can only be obtained from history. 

In fact, in order to assess the effectiveness of a particular trading strategy of a trader, the well-known Kalmar coefficient was invented, which, according to many investors, solves quite complex problems when choosing an investment object.

The Kalmar ratio was first presented in one of the most famous stock exchange magazines, Futures, by the author of a column on trust management and investing in hedge funds, Terry Young. This indicator is based on a concept known to all traders as drawdown.

And 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 is no secret that real trading is simply impossible without drawdown and so-called black bars. Agree, trading is a large series of transactions, and there is always a series of profitable and unprofitable transactions, but the main thing is that in the overall result the number of winning ones always exceeds the number of unprofitable ones. Actually, when trading, there is always a drawdown, and traders divide the drawdown into fixed and current.

A fixed drawdown occurs when a loss is recorded. For example, you have a capital of $100 and, as a result of an unsuccessful transaction, you lost $10. 10 dollars is ten percent of the capital and therefore your 10 percent recorded drawdown.

The current drawdown is the drawdown of the deposit at the time of opening a transaction, as well as its retention in the event of a loss-making direction. Actually, the current drawdown on the account is always present, because by opening a position using leverage , you at the same moment pay a deposit and a spread, which leads to a negative balance.

Actually, the analysis of the current drawdown is much more important than the analysis of a fixed one, since many traders do not use stop orders and open several positions, sitting out or averaging losses. However, it is the current drawdown that reflects the real situation on the account, despite the fact that the manager’s balance chart on the account remains unchanged, the amount of funds available for management becomes smaller, which at any time can lead to the loss of the deposit.

Also, in addition to the two types of drawdown listed above, there is such a thing as maximum drawdown. The actual value of the maximum drawdown is taken from the current drawdown, namely, it displays the maximum failure of funds relative to profit on open orders. It is the maximum drawdown that is taken as the basis when calculating the Kalmar coefficient.

Kalmar coefficient calculation

When calculating the Kalmar coefficient, only two values ​​are used, namely the compound percentage of profit taking into account reinvestment for a certain period of time, which is divided by the maximum recorded drawdown. Actually, this coefficient must be used when analyzing the profitability of a PAMM account or advisor over a long period of time, which should be at least a year.

Actually, why such a long period? The fact is that the formula is based on the so-called compound profit percentage, which is formed over a long period of trading by the trader, and the duration of stable trading is one of the main indicators of the viability of the account.

Let's take a more clear example of calculating the coefficient. Let’s say a trader showed a total return over the course of a year, taking into account reinvestment of 90 percent per annum. Due to the fact that the trader adhered to the management risk, the maximum recorded drawdown was only 10 percent.

So according to the formula 90/10=9. Do not forget that the coefficient can also be negative, which indicates the complete ineffectiveness of the trading tactics chosen by the trader.

The disadvantage of the Kalmar coefficient, which everyone is silent about

In conclusion, I would like to note that the Kalmar coefficient is one of the most popular indicators of the effectiveness of the strategy of a managing trader or advisor . However, this indicator has one drawback, namely, it is not time bound.

So, for example, if an account has been hanging around with zero profitability for a year, and in the last month a trader accidentally got on a good wave and earned 40 percent of the deposit, then the Kalmar coefficient can indicate good tactics of the manager, although in fact the strategy is unprofitable.

Also, do not forget that the minimum coefficient value must be no less than 3, since otherwise the strategy is not viable, and the drawdown and risks are much higher than the profit.