I have seen a lot of ads for trading systems. But, when I REALLY look at the drawdown, equity, and length of test period, it becomes obvious that these systems are barely profitable on a month to month basis.

Based on what I have seen over the years I must conclude that most of the folks selling trading systems either have no idea how to evaluate their profitability or are just fooling prospective customers.

Here's how I evaluate a system for profitability (the ability to make a profit).

First, I calculate the TOTAL EQUITY made during the system backtest. Then, I calculate the MAXIMUM DRAWDOWN that occurred during the test. Finally, I calculate the TIME of the test - the number of trading days that elapsed during the backtest.

I then multiply the drawdown by 10x. This means that during the worst drawdown an account trading the system would have experienced a maximum drawdown of no more than 10% of equity. I have found that traders HATE to have their account drawdown more than 10%. 20% is extremely uncomfortable, and anything beyond that is catastrophic. At 40% you can't sleep. At 50% you pick up the phone and sell everything.

Then, I assume 21 trading days per month (this is the average over time) and calculate a compound rate of return per month and an annualized rate of return based on 10x drawdown as the assumed account value.

For example, let's say a system to trade the S&P generates an equity of $200,000 with a max drawdown of $15,000. Sounds pretty good doesn't it? Now, let's say it took 5 years for this backtest. In 5 years there are about 1260 trading days.

So, we take the $15,000 drawdown and multiply by 10, or divide by .10. This gives an account balance to start of $150,000. If we then get a drawdown of $15,000 the account will still have $135,000 left. Drawdown will be 10% of the max account value.

So, the start balance is $150,000 and the net gain is $200,000, so the end balance is $350,000. Using NATURAL LOGS and EXPONENTS (use a financial calculator or stat program). I take the NATURAL LOG of $350,000 minus the NATURAL LOG of $150,000, and divide by 1260, then multiply that by 21. This gives me the NATURAL LOG of the net gain per month on a compound basis. I then take the EXPONENT of that number and I get 1.014.

NATURAL LOG of 350,000 = 12.766 minus
NATURAL LOG OF 150,000 = 11.918 = .847 / 1260 * 21 = .014.
EXPONENT of .014 = 1.01422.

This system produced a compound 21 trading day gain of 1.422%. Take this number to the 12th power (use Y to the X12 on the calculator - you are compounding the 1.01422 by 12) and you get an ANNUALIZED GAIN of +18.47%.

That isn't bad, BUT, you could probably have done just as well by putting your money into an S&P500 Index mutual fund thus saving yourself all the trouble of trading.

I used the HP14b Financial Calculator to figure this out, but all you need is any calculator or computer program that will compute NATURAL LOGS and EXPONENTS.

Try it with your favorite trading system. See if it's worth the trouble.