CHAPTER
19

Evaluating Performance

In This Chapter

• Pretrade testing
• Planning the trade
• Midtrading tracking
• Post-trade evaluation

At some point, a friend or family member is going to ask how you are doing, and as a matter of fact, it’s an important question you ought to be asking yourself independent of your nosy relatives. Are you some sort of financial genius, or should you fall back on the age-old advice, “Don’t quit your day job”? Basically, you need some sort of metric to judge how much money you are making, and how that stacks up relative to the time, money, effort, and sleepless nights you have invested in your strategy.

To get a better handle on your answer, we need to better define what we are asking:

• How are you doing overall?
• How are you doing relative to the market and relative to your peers?
• How does your return on trading options compare to a money market account?
• How does your return on trading options compare to an index fund?
• Do you want to look at it for individual trades, or in aggregate?
• How do you account for options that haven’t been exercised yet?

These questions fall under the umbrella of performance evaluation. The simplest answer is to compare what you have now to what you had when you started. If you’re ahead, it’s all good, right? Not so quick; you need to evaluate whether the net difference is fair compensation for your time and risk. A careful, quantitative analysis can help you fine-tune your strategy to improve your performance over time.

This section will discuss a trial run (simulating how you will do without actually doing it), record keeping, and a few methods to quantitatively evaluate your performance.

Learn About Options, Not Strategies

It might seem like options trading is about learning a lot of complicated strategies with strange names. The options business has always seemed like something apart from regular stocks and bonds. The lore of the trading pits and the role of options trading in the media reinforce the idea of options as something different and difficult, and many new options traders think they need to learn the complicated stuff first.

In fact, it’s the opposite. Start with the basics: what a put is, what a call is, what it means to write and to buy, and how the prices change. If you understand the basics, you’ll be able to think about the payoffs as you put together trades. Simulation trading helps. Focus on this before worrying about butterflies, condors, and Christmas trees. The simple stuff will carry you through.

Testing Before You Trade

Performance evaluation starts before you trade. If you’re speculating, you want some idea of how your strategy will work. If you’re hedging, you’ll need a sense of what your potential downside is and what it will cost to buy protection.

Start by watching the markets. Create a few trades—or a full-on strategy—and see how they play out before you commit actual money. How did that work out?

This process is known as simulated trading. You can start by simply making a note on a piece of paper on in a spreadsheet about your trade idea, then checking to see how it would work. Some questions to ask include the following:

• If you want to write covered calls, what is the premium you would receive?
• How does that compare to the risk of the underlying asset being called?
• If you wrote a covered call today, how likely is it you would want to close the trade in the next day? Week? Month?
• What would it cost you?

Think of this as watching the waves before swimming in the ocean. It’s better to identify the undertow before you get caught in it.

Keeping notes of trade ideas will get you started, but most brokerage firms and many of the exchanges offer simulated trading systems. One to try is the CBOE’s virtual trade tool, which you can find online.

Simulated trading lets you try out your ideas and see how they work with play money. It gives you a really clear idea of what you do and do not understand about options trading, and it lets you test new trade strategies without risking actual cash.

Keep in mind that with play money, you might not have the emotional attachments that undo traders. Some people do really well with play money, then panic when they deal with the real thing.

Assuming you’re happy with the results, you can move on trading small amounts of real money. If not, go back to the drawing board and think of some new trades.

Backtesting

If you’re planning to be a frequent options trader, especially a day trader, you might want to see how your strategy would have worked in the past. That’s why many brokers offer backtesting services. You can run your trading system with historic data to see how it would have performed in times past.

Backtesting is especially useful for seeing how your trading would work under different market conditions than you see right now. It can help you evaluate whether to change your strategies if current market conditions change, and it can give you a sense of the amount of risk you are taking.

When you set up a backtest, you specify the types of trades you would make, and the time they would run. One of the things you are looking for is the number of opportunities that come your way given your strategy. Nothing works in all markets, all the time, and some profitable situations might not appear often enough to be worth your while.

And don’t worry, the markets will change. As traders like to say, the four most dangerous words in the English language are “this time is different.” History repeats itself in the options market as it does anywhere in life.

Simulation

Sometimes called paper trading, simulation is similar to backtesting in that it lets you run a strategy without committing any money. The difference is simulation works in current market conditions rather than with past data.

With most simulated trading systems, you can either trade in real time, placing buy and write orders, or you can specify the parameters of automated trades and watch them play out. You might be looking for specific signals to buy and to sell; you would enter those to see how they work.

Both backtesting and simulation have the same problem, which is that you’re not trading with real money. That means you might not be affected by emotions the same as you will be when trading in real time with real money. That’s okay; they both give you a starting point. If your trading system does not work in a simulated environment, it isn’t likely to work in the real world, either.

By ruling out a less-than-ideal strategy, you can concentrate on those that have a greater chance for success. That’s all you’re doing here.

Tracking Trades

If you are satisfied with your backtesting and simulation performance, either using historic data or real-time markets, you can move on to trading with real dollars. When that happens, it is critical that you track your trades so you can evaluate your performance.

The good news? It’s not hard to do.

A Simple Trading Diary

A trading diary is a record of each trade you placed, why you placed it, how it worked out, and why it did or did not work out. This can be maintained along with a trading spreadsheet or kept separately.

A trading diary does not have to be fancy. Plenty of traders use old wire-bound notebooks they keep next to their computers. Others make a form they copy and keep in a loose-leaf binder. The important thing is having notes in real time, rather than waiting until a day or a week later when the passage of time and the color of emotion might influence your recollections about why you traded and how it worked for you.

Here’s what each diary entry should include:

• Date and time the position was opened
• The name, option, strike, and expiration
• Number of options purchased
• Premium paid or received
• Reason for making the trade
• Date and time the position was closed
• Price at which the position was closed
• Reason for closing the trade
• The realized gain or loss (Track it now to make your life easy at tax time.)
• A brief explanation of the trade and note of any lessons learned

If you keep track of your trades as you open and close them, you’ll be able to see what you did and why it worked (or didn’t), free from the haze of memory and emotion.

Spreadsheet

Many brokerage firms provide trade tracking services. They collect the data in a format that can either be analyzed on their platform or downloaded into a spreadsheet so you can analyze it yourself.

Setting Up a P&L

P&L stands for “profit and loss,” and it’s the record of what you’re making from your trading. This is an extension of the trading log. If you keep your trading diary in electronic format, you can calculate your P&L there.

It’s pretty simple: how much did you start with, how much did you end up with, and what is the percentage change? If you trade daily, set it up daily. If you’re less active, check less often.

If you are trading on a regular basis, it might make sense to see what your hourly wage is as well. If your week’s profit is $100 and you spent an hour trading, you’re doing okay. If you spent 40 hours trading, maybe not.

Calculating Overall Performance

Finding your basic profit and loss is a simple process. Other measures of performance are strangely complicated. It seems simple—how much money you have at the end compared to how much money you have at the beginning. The problems ensue if you add money to your account, take money out, or want to figure out what your return is for different time periods. You might not care about this information, or it might be useful when comparing your performance to that of professional managers.

The absolute amount of money you make from trading only tells you part of what you need to know. The other part is determining how you perform relative to the amount of risk you take and relative to other things you could be doing with your time and money.

Types of Return

When people in the financial markets talk about return, they are thinking about a few different forms of calculations. There are a few different calculations that have different uses in performance analysis. You might only care about very basic return info, or you might want more detailed statistics. You might also want to understand what a research service is talking about when it makes claims for its performance. No matter the reason, this section will help you out.

Compound Average Rate of Return

The compound average rate of return starts with a simple percentage change equation. It is used for a single time period in which no money was added or withdrawn. If you wanted to compare how much money you had at the end of the period (EOP) with how much you had at the beginning of the period (BOP), the equation you use is:

EOP ÷ BOP – 1

That’s simple.

The compound average rate of return for one time period is probably given on your brokerage account statement. If you’re looking at more time periods, the math gets a bit trickier. You’re now looking for the compound average growth rate (CAGR), which is also known the geometric mean. Mathematically, it is the nth root of n numbers multiplied together. The equation looks like this:

The easier way to solve this is to use the GEOMEAN function in Excel. This metric evaluates what your returns would have to be over a period of time to achieve the same net result, and it allows you to smooth out the ups and downs to come up with an overall average. If you earn 10 percent return on each of three years and lose 20 percent during a fourth, then your geometric mean return is 13.5 percent.

Time-Weighted Return

A true time-weighted return is a bit of a mess to calculate to hand, but it gives you the clearest information about how an investment did with money coming in and coming out. The good news is your brokerage firm might calculate it for you.

Here’s what goes into the calculation. First, you find the compound average growth rate for each time period before an addition or withdrawal of money is made. Then, you do another CAGR starting the day of the deposit or withdrawal, then taking it out until right before the next deposit or withdrawal, and then so on. The time period is usually the number of days. Then, all of the CAGRs are multiplied together to get you the return for the year.

If you are looking at different money managers or commodity trading advisers to handle your options investing, you’ll want to see their time-weighted return information. That will give you a good idea of how they handle investments with money coming in and coming out.

Modified Dietz Method

The problem with the compound average rate of return is it does not handle additions and withdrawals of money. If you want to see how you are doing relative to professional traders, or to compare your results to a fund’s results, that’s an important number to know.

Here’s what the Modified Dietz Method looks like:

(EOP – BOP – deposits + withdrawals) ÷ (BOP + deposits – withdrawals)

The only problem with this is that it doesn’t consider when the money came in. In this calculation, a deposit in January would have the same effect as a deposit in December, even though in reality, the effects on performance would be very different. Still, it helps break out an increase in account value between an increase from investment returns and an increase from new deposits.

Dollar-Weighted Return

Also known as internal rate of return (IRR), the dollar-weighted return is the rate of return that makes the present value of a stream of numbers equal to zero. It has a lot of value for calculating the returns in which all of the numbers are positive, and so you see it often in calculating returns on bonds and venture capital. It has less value for options, where you’ll almost definitely have a few losing trades.

But, if you come across it, here’s the information on calculation. You either use the IRR function in Excel or in a financial calculator.

Arithmetic Average

An arithmetic average of profit (or loss) on trades is a number you want to know to help improve your trading. It is nothing more than calculating the individual return for each period, summing them all up, and dividing by the number of periods. (This is the calculation that the AVERAGE function in Excel does.) If you double your investment for two years and lose it all during the third, on average, you increased your money by one third each year, which isn’t a particularly good measure for how you did in any given year, or how you did overall.

This number is not so useful finding out the return on your money, but it is helpful in risk calculations, covered in the next section. Knowing it puts you way ahead of traders who figure they are doing all right because they still have money in their accounts.

Risk Calculation

Return gets you to one point of information. The other point is the rate of return relative to the amount of risk you take—risk calculation. After all, a big return earned on very little risk is a lot better than a big return for an even bigger level of risk.

Return is a function of risk, by the way. You don’t get a big return without taking a big risk. That’s another reason not to trust braggarts at cocktail parties.

Batting Average

A lot of traders look at their batting average—the percentage of their trades that make money to the percentage that lose money. Also known as their win-loss percentage or win ratio, it gives you a sense of how effective your trading strategy is. It is also useful in many money management systems covered in Chapter 17.

If you are dependent upon a few huge wins to offset a typical losing trade, your strategy has a lot more risk than if a larger number of trades win, even if they generate a smaller amount of return.

Standard Deviation

Standard deviation is one of the numbers your P&L spreadsheet can generate for you. The math looks at how much each particular trade’s return deviated from the average trade. In fact, it’s the same equation used to describe the volatility of an underlying asset.

The higher the standard deviation, the greater the volatility of your returns and the greater the risk you are taking in your portfolio.

Sharpe Ratio

Once you have the standard deviation, you can find the Sharpe ratio, which is nothing more than the return divided by the standard deviation. The higher the Sharpe ratio, the greater the return relative to the risk taken.

Benchmarking Performance

If I said I earned 10 percent on my money last year, would that be a good return? Suppose I said I lost 5 percent, would that be good?

Obviously, it depends! And what it depends on is the return available elsewhere in the market, the return for the amount of time committed to trading, and the amount of risk taken.

This section will look at the factors you need to compare to your trading in order to determine how you are doing.

Relative to a Market Index

The alternative to trading options is to invest directly into a market index fund, commodity trading account, bond, or currency. One way to see how options are affecting your return is to compare it to an appropriate index.

You can use the relevant underlying index to see if you are getting benefits over and above investing in the underlying asset directly. This is especially useful if you are using options to hedge.

In addition, the Chicago Board Options Exchange publishes a buy-write index that can give you a sense of how a covered-call strategy should perform. If your primary interest is covered calls, this is a good way to track your performance.

Relative to the Time Committed

Trading takes up time. You might be doing it full-time as a form of employment or part-time as an activity designed to make money, as a productive hobby. Whatever the reason, you’re putting time and energy that could be put to a different endeavor into the trading.

And so, a very simple but important calculation is to take the amount of money earned from trading, after costs, after subtracting out the initial investment, and dividing it by the number of hours spent.

One Final Note

As every investment industry disclosure says, past performance does not indicate future results. Go forth and trade, but remember tomorrow might not be like today.