(This is a followup to this post where we took a look at the risk implied by smaller vs larger stops.  A good grasp concept of expected value from that post is essential to this post as well.)

One of the problems traders face is knowing how to really nail down and to quantify our trading results.  At the end of the day/week/month, the P&L is ultimately the final measure by which we are all judged, but, especially for developing traders, how do you know you really have an edge?  It is certainly possible to be lucky doing the wrong thing and make money over any given period, just as it is possible to be doing exactly the right thing and still be down money.  The purpose of this post is to get you to start thinking about the issues involved in understanding your trading results, and to point you in the right direction for a good record keeping system.

The first requirement, of course, is a perfect set of records.  You must have a continuous record of all your trading activity with no omissions or errors.  Most brokers offer some sort of accounting package that will help you in this regard, but it is essential you have no errors, omissions or double entries in this record.  If you do not have such a record of your trading activity, then it is very hard to take yourself seriously as a trader.  Start right now, today, and build the record from this point forward.  As an aside, you will probably find you are much less motivated to do this record keeping when you are on a bad streak, whether it is days or weeks.  Learn this psychological clue — the less you want to do this, the more important it is!  No joke.  We are in a performance discipline and, without good records, it is impossible to really evaluate your performance.  Your mind will play all kinds of tricks and offer all kinds of excuses, but if you find you can’t keep these kinds of records consistently your chances of making it as a professional trader are very small indeed.

Once you have this set of records, the next step is to standardize your results somehow.  For instance, at SMB our new traders start trading with 100 – 200 shares in every stock they trade.  It certainly would be possible for that trader to have, say, 10 winning trades in KBH and one loser in AAPL and be down a significant amount of money on the day.  (Our new traders also do not trade AAPL, but just go with me on this one.  I’m making a point.)  The obvious answer to this is to standardize your results as a percentage of the stock price.  This is standard practice in most other aspects of Finance where people typically look at returns (percentage returns or continuously compounded (log) returns) rather than simple dollars made or lost.

Another possibility that works for me is to standardize each of your trades as a percentage of your risk on the trade.  This adds another layer of complexity to your record keeping because I think it is critical to record what you thought your risk was at the time you entered the trade.  Avoid the tendency to revise history.  If you get in a trade thinking you are risking $500, but you get stubborn and end up losing $750 you must not record this as a trade with $750 risk.  You intended to risk $500, so your $750 loss actually represents a loss 150% if your intended risk.  Be honest and be brutal with yourself — however tough you are on yourself, the market will be tougher.

Lastly, two other stats that may be interesting are Maximum Adverse Excursion (MAE) and Maximum Favorable Excursion (MFE).  These sound complicated, but they really are simple and can help you evaluate the efficiency of your exits.  MAE is simply how far the trade moved against you before you exited, and MFE is how far it moved in your favor before your final exit.  There are several ways to use these, which we will examine in a future post.

To summarize, evaluating your results starts with having a good set of records.  I would suggest keeping the following set of records for every trade:

• Date and Time for entry
• Date and Time for each exit
• Ticker
• Share size for each execution
• Price for each execution (these are obvious, but it has to be said)
• Intended total risk on each trade at the time of trade entry.
• And, if you’re well motivated, record the maximum distance the trade moved in your favor and against you between your entry and final exit.

We will look at what to do with these numbers in my next post.  Follow me on Twitter: AdamG_SMB

Part 2 can be found here