Pre-warned, this is only one of the methods of evaluating the effectiveness of the strategy, which of course may not be perfect. But as a precaution, it is a working tool. Besides, a professional trader needs to know every possible tools in order to use them to create something of his own or to find what is most comfortable to him.
The Sharpe ratio: performance evaluation TC
The effectiveness of the strategy is compared by their profitability on a relatively equal interval of time, but it is only a superficial judgment. For example, two different strategies can show the day of the same yield, but have a different risks. In other words, often the situation when a less profitable strategy is more effective due to minimal risk. We should not forget about the market situation: one strategy may be effective in volatile markets, the other on a specific currency pair depending on liquidity.
The Sharpe ratio is used to evaluate financial assets and investment portfolios, but in Forex it is also can be used.
Calculation formula: Sharp = (R — Rf) / Si
The essence of the Sharpe ratio in relation to the difference between the yield and the risk-free income of trading strategies to risk:
- R — income for a fixed period. In relative and absolute terms the profitability of the strategy can be found in the statistics of the trading platform MetaTrader. It is desirable to use the return over the period of 1 year and above;
Only a professional with a good patience will be testing a new strategy for more than a year. Because most often, the Sharpe ratio is used in the purchase of existing strategies (or the estimation of their free versions) based on the statement — the decryption key indicators of trading tactics.
- Rf — risk-free return (usually applied to the stock market). Example: short-term Treasury bills. For foreign exchange market this option is omitted, though it is wrong. I would recommend to take into account as a risk-free factor, for example, income from exchange rate differences (if initial deposit would be in cash) or return of the Deposit in the Bank;
- Si — deviation of return. Is the average volatility of the currency pair in the same expression as the yield (the percent or quantity of unit).
For the optimal value of the adopted coefficient of “1” that means a good strategy. If the Sharpe ratio is below “1”, it is not very good, but tolerable. The negative value of coefficient – the strategy is unprofitable.
- Initial deposit — 100 USD;
- Trading period — 1 year;
- Profitability for a year — 250% or 250 USD of profit;
- volatility of the currency pair for a year (the difference between the initial and final value of the rates) — 124 points.
Sharpe Ratio = 250/124 = 2,01. A good strategy.
- initial deposit— 500 USD;
- trading period — 1 year;
- profitability for a year — 60% or 300 USD of profit;
- volatility — 1342 points.
Sharpe Ratio = 300/1342 = 0,22.
Conclusion: in the first case the yield at a given volatility is very fantastic. Or should I look for the catch, or the trader is very lucky. In the second case the opposite applies to a high-risk strategy with a large income. Selecting a second strategy, the trader may either earn a lot, or lose it all. And if it was obtained optimum value of “1” with a small deviation, the strategy could be called optimal.
The absence of a factor of risk-free income distorts the calculations, because at the end the ratio is 100% guarantee the profitability of the strategy, that is not true in fact. Take this into consideration when you test the operation of the tool in practice!