Sharpe ratio - evaluate the effectiveness of your strategy
Good day, comrades Forex traders! More often, when evaluating strategies on Forex, traders look at the percentage yield. The more there are, the better, right? But the% return is highly risk-dependent and does not reflect the effectiveness of the system. So which indicator to use? A standard among financial analysts is considered Sharpe Ratio, bred by Nobel Laureate William Sharp.
Below we will look at how to calculate the Sharpe ratio to assess the effectiveness of the strategy, see what it means (many people know how to count it, but do not understand its meaning), and also draw conclusions about when it is useful and in which it is not.
Sharp Forex Ratio
Sharp coefficient was invented by the famous American economist - William Sharp. Today, this is one of the most commonly used indicators of risk to return ratio. The coefficient became even more significant when, in 1990, Sharp was elected a Nobel Prize laureate for his financial asset valuation model (CAPM).
It will not be difficult for a person from the financial sphere to understand the principle of calculating the Sharpe ratio and what he should display. In essence, the task is to find out how much excess return you will receive in connection with the retention of a more risky asset. I think it is no secret that excess risk should always be fully compensated for by the corresponding profitability. The larger the coefficient value, the greater the risk profit of the same amount.
The calculation formula is as follows:
Profitability can be measured at any frequency — it can be a day, a week, a month, or a year. Also, as an indicator of profitability, you can take the average gain per transaction. The only thing that is desirable is that the initial yield data should be normally distributed. Hence the main weakness of the coefficient. Sharp peaks in a sample of 3 or more standard deviations and asymmetric distribution (apparent slope of the graph) can cause a false estimate.
Risk-free income is theoretical income with zero risk. That is, this is the profitability that an investor can get absolutely without risk for a certain period of time. In theory, this is the minimum income that an investor expects to receive from any investment. Comparing this indicator with real income, you can determine how good compensation you get for the additional risk.
In practice, the concept of zero-risk investment does not exist, since even the safest investments carry some risk. Nevertheless, the risk-free return can be attributed to a deposit in a savings bank, or money invested in US treasury bonds. The forex market is always a high-risk investment, so the risk-free return in our case will be zero. But, if your deposit is stored in the bank, you can substitute the value of the current base rate into the formula.
In the MT4 terminal, the Sharpe indicator is considered as the ratio of the arithmetic average yield of the transaction to the standard deviation, at a zero value of the risk-free rate.
The full formula looks like this:
The Sharpe ratio measures investment performance in terms of income dispersion. Since we have already calculated the excess return (yield minus the risk-free rate), it remains to divide this value by the standard deviation of the asset's return. That is, calculate the ratio of return to risk.
Although this is no longer required today, the standard deviation is not difficult to calculate manually. Suppose you have collected a small statistics of the profitability of transactions: 3%, 4%, 5%, 2%, 1%. At the first stage, we subtract the average from this sequence and get the following series: 0%, 1%, 2%, -1%, -2%.
Next, we square the values, we get the arithmetic mean and derive the root of the result - sqrt ((0.00% + 0.01% + 0.04% + 0.01% + 0.04%) / 5) = 1.41%.
For comparison, let's take a slightly different selection: 2%, 8%, 5%, 4%, 6%. Obviously, the profitability of such a system in the framework of the period under review is greater, but we also observe a much greater profitability volatility, 2% against 1.41% in the previous example. Accordingly, the first strategy is less risky.
Sharpe ratio units
For example, let's try to compare the effectiveness of two trading strategies in terms of their profitability and risk. Suppose the first strategy gives 5% profit per trade, with a standard standard deviation (rate of return variance) equal to 4%. The second strategy on average brings 2% in each transaction, but the deviation does not exceed 1%. In this case, the first strategy will have a sharpe ratio of 1.25, and the second - 2.0. This means that in spite of lower profitability, the second strategy has a better risk to return ratio.
The Sharpe ratio must be equal to one or higher. Then it is believed that the strategy that we are analyzing works with sufficient efficiency. A value of more than three already indicates that the probability of a loss in each transaction is less than 1%. And the greater the value, the better.
In most cases, the Sharpe ratio will show the real profitability of the strategy. But, sometimes, Sharpe's metric can be misleading. For example, some bonds may show stable returns above bank interest for many years, which the coefficient will respond with unrealistically high rates. In this case, the obtained value will not say anything about the real risks behind investing in this bond, even if the risk is actually minimal. In general, this coefficient is suitable for comparing two strategies with relatively frequent inputs and not the most huge goals.