There are various methods of evaluation of trading strategies in financial markets. Many investors analyze the efficiency of trading on the equity (the amount of available funds on Deposit). In the case of smooth growth curve that is the result of the back test and the lack of sharp drawdowns, the trade is successful. In addition to this method, applied parameters such as percentage profitable trades, maximum drawdown and others.
However, for a more complete analysis requires consideration of commercial risks. To evaluate the ratio between risk and return helps the Sharpe ratio (Sharp Ratio).
Calculate the Sharpe ratio
Most investors “gets the bait” beautiful growth figures of funds on Deposit, not taking into account the degree of risk. A tool such as the Sharpe ratio, to determine the effectiveness of the investment portfolio, calculated by the ratio of average income from trading the level of risk. The higher The ratio, the more efficient way to trade.
It is possible to see how previously profitability was correlated with the risk, and to predict the stability of future performance. The standard formula for the calculation of this indicator are as follows:
Sharp Ratio = (Rp − Rf) / σp,
where Rp is the expected profit for a given period of time, Rf — risk-free return, σp is the risk of the investment portfolio. The risk is expressed as a standard deviation from the expected average return.
Negative values of the Sharpe ratio reflects too much risk in the trade. This strategy is not recommended. “A good indicator” Sharpe should be from one and above. Only then the method of trading will be considered effective. The value of Sharp Ratio greater than figure 3 suggests that the magnitude of the probability of loss in each transaction does not exceed 1%. A further increase of the Sharpe ratio shows the growing effectiveness of the trading strategy, but too high values signal potential error in the calculations.
As an example, it is possible to compare the effectiveness of two ways of trading for profitability, and standard deviation. The first method brings a 6% return on one trade at the risk of the investment portfolio of 5%. The second gives a 3% yield at a deviation of 2%.
The Sharpe ratio of the first strategy is equal to 1.2, the second — 1.5. This suggests that even yield twice the smaller size gives a better proportion of profit to risk.
The Sharpe ratio in the Forex market
The Sharpe ratio is very important to analysis Forex accounts. It is successfully applied for monitoring of many Western investors. Applying this ratio, you can immediately determine whether the trader trades with fixation losses or not. Quite often the managers with the increasing size of funds on the account, but with a low Sharpe ratio (in the range 0-0.5). Often this result shows the same probability of earnings and loss.
In MetaTrader 4, this option can be seen in the “Signals” section. Its value helps to evaluate the effectiveness of the chosen trading strategy of the trader. This section presents the detailed analysis.
In the Forex market this indicator displays the excess return that you can get hold more risky asset. Of course, that increased risk should be compensated by a more significant profit.
In the formula for Sharp Ratio = (Rp − Rf) / σp Rf = 0, since the Forex market is not risk-free income. Rf current in the stock or debt markets. There it can be observed in the form of dividendnoj yield or payments on the bonds.
There are several features of the Sharpe ratio:
- The indicator measures the volatility of yield and the cost of trading instruments does not affect the calculations.
- For the studied period of time the calculation does not depends on the particular sequence of profitable trades from unprofitable.
The yield of the asset
It is measured with any frequency. As the unit of measurement choose the days, weeks, months, or years. In addition, the profitability of the asset can be the average gain per transaction.
Very important normal a symmetrical distribution of the original data. When present on the chart analysis of the asset several sharp non-standard deviations (significant peaks, troughs) increases the probability of a false assessment.
When the investor is testing many different strategies would be helpful to make a table in Excel to develop the calculation formula and add new data.
The standard deviation
The standard deviation calculation in the trading terminal automatically. This indicator allows you to determine exactly how that will change (decrease or increase) the profitability of the selected asset in comparison to the average yield during the selected time period.
For clarity, you can assess the risk strategies, comparing two different data samples.
In the first case, the profitability of trading transactions amounted to: 3%, 2%, 5%, 0%, 4%. The average value is 2.8%. The result for subtracting from each of a rate of return equal: 0.2%, -0.8%, 2.2%, -2.8%, 1.2%. During the construction of each value in the square you want to compute their sum, then find the arithmetic mean from the values obtained, calculate the square root:
Sqrt((0.4% + 0.64% + 4.84% + 7.84% + 1.44%) / 5) = 3.03%
In the second case, the profitability of trading transactions amounted to: 2%, 1%, 0%, 4%, 6%. Their arithmetic average is equal to 2.6%. The results are similar to the previous method of operation: -0.6%, -1.6%, -2.6%, 1.4%, 3.4%. Then, as in the previous case:
Sqrt((0.36% + 2.56% + 6.76% + 1.96% + 11.56%) / 5) = 4.64%
The result of The comparison, the first strategy is less risky than the second because the volatility of yield it less.
Although the Sharpe ratio is one of the important benchmarks of risk-adjusted returns, it should be used along with analytical information.