Whatever strategy you use in your forex trading career, it will be necessary to measure performance accurately. This goes beyond just P&L – overall performance takes into account factors including risk, maximum drawdowns, and risk adjusted returns. Only the most basic of these metrics are recorded automatically on electronic trading platforms, so it is important to understand how they work and how to calculate them.
What is performance measurement?
Performance measurement is a financial discipline that aims to provide information on the performance of individual trades and trading portfolios. To do this, different data sources are collected to try and understand how a particular trader is functioning, both in terms of profitability (P&L) and also risk exposure and potential or realised losses (drawdowns, risk adjusted return).
Whilst retail traders do not need to use some of the sophisticated techniques used in banks to measure the performance of vast portfolios or teams of trading professionals, it is still a very good idea to know which metrics are most effective to measure both your absolute and risk adjusted performance.
One of the most important distinctions is between realised and unrealised gains (or losses). Unrealised gains are those involved in trades that are still open, and are constantly subject to revision, whereas realised gains are only those where the trade has settled and the sums involved can no longer change.
Profit and loss, known ubiquitously as P&L in financial markets, refers to the overall gains and losses of your portfolio calculated as the profits from successful trades less the losses from failed trades.
Ultimately P&L is the only long-term measure that most people are interested in and provides the bottom line to your success or failure in the forex market. However, it is important to also think about the other contributing factors and risks that you should be measuring in your portfolio.
P&L is only calculated after a trade has been closed. An unrealised profit or loss on an open trade does not contribute to a traders P&L until it has been settled. Therefore this is a more useful measure for overall performance than up-to-date conditions.
Drawdowns and maximum drawdown
Most people do not like losing money, even temporarily. Drawdowns are a measure of the maximum loss in value in a portfolio, regardless of whether the trades have been exited or not. The difference between P&L and drawdowns are that drawdowns are temporary – the maximum drawdown is therefore the lowest value of the portfolio, regardless of whether it later increases.
This is an important measure because risk-averse investors will always seek to minimise drawdowns. A maximum drawdown of 30% on a $1000 portfolio would mean unrealised losses of $333. Normally for forex traders drawdowns are significantly lower than this, as most use quite tight stop losses that don’t allow for such large unrealised downwards moves.
In theory, drawdowns do not matter to your overall portfolio returns. In practice the metric is a little different. Constant vast drawdowns, even if your strategies are eventually successful, could be a sign of poor market timing or just a lack of proper risk management. The risk adjusted return uses your maximum drawdowns and profits to calculate an overall metric.
Risk adjusted return
Forex risk management strategies involve the balancing of potential gains to maximum drawdowns. One factor to remember is the risk adjusted return, which is a special kind of performance metric. The risk adjusted return is a measure of the potential or actual return of a trade, when allowing for the maximum possible or realised loss.
Ignoring risk adjusted returns can result in absurd scenarios: A long USD/JPY trade at 128.3 with a stop loss at 100.0 at take profit at 130.0 is very likely to be successful, but could incur an enormous drawdown in the process. This sort of (ill-advised) trading is thankfully uncommon in the forex market, but will be very familiar to equity investors.
A trader with a portfolio full of trades similar to the one described above may perform very well on his realised P&L, but he is taking an enormous ‘long-tail’ risk that eventually his stop losses will be trigged, wiping out the returns of many trades in one swoop. Realised P&L will not reveal this danger, as only those trades which have closed out will be included.
By checking your current and maximum drawdowns you can gain a snapshot of how much downside risk you are currently exposed to, and using risk adjusted performance metrics alongside P&L helps to give you a broader a view as to your overall effectiveness.
Performance measurement and risk management
In order to manage a financial risk, it first needs to be identified and ideally measured. The aim of accurate performance monitoring is to understand both how well your trades perform, and also how much market risk you are taking on to achieve that. This can sometimes be masked when you solely use P&L to measure returns.
In addition to the positioning of stop losses, leverage can also drastically affect performance returns. Factoring in the cost of margin calls, and the levels at which they can be triggered, must all be included in performance management. Again, for completed trades, these will be reflected in the P&L, but until that point additional measures are required.
The above metrics can be used on individual trades or also at the level of the entire portfolio, a practice sometimes referred to as portfolio measurement or portfolio reporting. In large and especially in mixed asset class portfolios the discipline of portfolio reporting is of great and increasing importance.
Portfolio reporting involves studying the correlations between the various assets held in the portfolio in addition to their maximum drawdowns and market performance to create an overall picture of risk levels and performance. For most retail forex traders this is not a massive concern, but a similar requirement can appear if you use many different product types.
For example, a retail trader with an FX portfolio including options, forward and spot trades in different amounts and with differing expiries might not be able to immediately see his own exposure and potential returns. This is especially true when leverage is involved.
Relevance to retail investors
Investors with relatively small portfolios built out of simple spot FX trades, who follow risk management best practice in their position sizing, probably don’t need to worry too much about drawdowns or risk adjusted returns. For large numbers of retail investors, P&L (realised and unrealised) is a perfectly adequate method to check your portfolio’s performance.
Those traders that use multiple different derivatives products, or strategies allowing for major drawdown periods, or simply those with larger portfolios that are tougher to keep track of would do well to understand the different metrics explained here. There is really no limit to how far you can go in portfolio reporting – and having a good background understanding of the disciplines is important for any forex trader.
Summary of key points
Performance measurement is an expansive topic with entire divisions dedicated to the discipline at banks and major trading companies. As a retail trader, there are a few key points to takeaway:
- P&L is the ultimate and most important of your performance metrics. The final goal of a transaction is to make money. However, it is not the only one, and doesn’t include information about open trades.
- Open P&L – the expected profit if you closed a trade immediately, can be misleading.
- Drawdowns measure the unrealised losses of a portfolio.
- Risk adjusted return takes into account both drawdowns and expected returns.
Monitoring performance involves looking at both realised and unrealised trades, and forms a vital part of your overall risk management. Understanding the complexities and challenges of portfolio reporting can help you get to grips with your own trading in a way that will see you making better trades more aligned with your risk management objectives.
How Rakuten can help
Performance measurement is one aspect of mastering forex trading. If you are ready to start putting into practice your new knowledge on the topic, why not open a free demo account today and begin trading without risking any of your capital?