How’s your Sharpe ratio* at the moment, or your Sortino ratio*, are they where you’d expect them to be, perhaps after a full twelve months of trading using your revised (tweaked) trading strategy? Even with that one introductory sentence we know a significant percentage of our readers will already be lost…
However, fear not dear readers, as we’ll not only explain exactly what these terms are, but also how they can be used to good effect in the recorded trades element of our trading plan. And moreover we’ll explain how recording our individual trades’ performance is an absolutely critical aspect of our trader development.
Over the coming weeks (each week) we’ll take one aspect of our trading plan and explain it in detail. We’ll then explore why it’s so important for us to pay attention to this particular feature of our trading plan. Naturally, after reading the article, please feel free to communicate with us by way of the comments feature.
Where are we if we don’t forensically analyse our returns and performance?
We’ve mentioned this before in several articles, but we believe it’s worth repeating until it sinks in; trade as if you’re a professional in every way. Mimic the behaviour that you’d expect to be judged by if you were working in a large corporation.
For example, if your boss suddenly pitched up on your desk and asked to see a record of all your trades it’s not enough to refer to your trade blotter. You’d be expected to produce a lexicon of information regarding your current performance.
Or perhaps view it from a different angle. Imagine you’re pitching your trading plan and performance to a group of investors, it wouldn’t be enough to simply turn up and describe what you’re currently achieving, and investors need to see proof. That proof would have to be bullet proof and one of the very first results an investor would likely ask for is the Sharpe ratio.
What should be in our trade records?
Quite simply every trade we take should be transferred to the trading ledger of our plan and this can be easily execute given that many brokers will provide you with listings easily transferable to, for example, excel spread sheets. Thereafter we can subject our trading performance to the mathematical analysis such as Sharpe and Sortino ratios.
Where to find these complicated sounding ratios and how it implement them into your trading plan isn’t easy, but it is straightforward and it requires us as individual traders to put a bit of extra effort into discovering if (out there in trader land) there’s any calculators were you can import your trades to discover you current ratios. The internet really is your friend and you’ll find many examples out there if you DYOR – do your own research. Finally we’ll leave you with a brief snapshot and breakdown of how the ratios are calculated.
*Sharpe ratio
In finance, the Sharpe ratio (also known as the Sharpe index and the reward-to-variability ratio) is a way to examine the performance of an investment by adjusting for its risk. The ratio measures the excess return (or risk premium) per unit of deviation in an investment asset or a trading strategy, typically referred to as risk (and is a deviation risk measure), named after William Forsyth Sharpe.
The Sharpe ratio characterizes how well the return of an asset compensates the investor for the risk taken. When comparing two assets versus a common benchmark, the one with a higher Sharpe ratio provides better return for the same risk (or the same return for lower risk). However, like any other mathematical model, it relies on the data being correct. Pyramid schemes with a long duration of operation would typically provide a high Sharpe ratio when derived from reported returns, but the inputs are false. When examining the investment performance of assets with smoothing of returns (such as with-profits funds) the Sharpe ratio should be derived from the performance of the underlying assets rather than the fund returns.
The Sharpe ratio has as its principal advantage that it is directly computable from any observed series of returns without need for additional information surrounding the source of profitability. Other ratios such as the bias ratio have recently been introduced into the literature to handle cases where the observed volatility may be an especially poor proxy for the risk inherent in a time-series of observed returns
*Sortino ratio
The Sortino ratio was created by Brian M. Rom at the software development company Investment Technologies in 1983. The ratio is named for Dr. Frank A. Sortino, an early popularizer of downside risk optimization. It measures the risk-adjusted return of an investment asset, portfolio or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target, or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally. Though both ratios measure an investment’s risk-adjusted returns, they do so in significantly different ways that will frequently lead to differing conclusions as to the true nature of the investment’s return-generating efficiency.
The Sortino ratio is used as a way to compare the risk adjusted performance of programs with differing risk and return profiles. Any risk adjusted return is just trying to normalize the risk across programs, and then see which has the higher return unit per risk.[1]
The Sortino ratio is used to score a portfolio’s risk-adjusted returns relative to an investment target using downside risk. This is analogous to the Sharpe ratio which scores risk-adjusted returns relative to the risk-free rate using standard deviation. When return distributions are near symmetrical, and the target return is close to the distribution median, these two measure will produce similar results. As skewness increases and targets vary from the median, results can be expected to show dramatic differences.
