What is the Sharpe ratio? Its advantages and disadvantages.

 

What is the Sharpe ratio? Its advantages and disadvantages.

Sharpe Ratio, can be interpreted in different ways, but with the same semantic meaning:

1. Shows how effective the investor's portfolio is. The ratio of average income to average deviation is therefore income.

2. Demonstrates the effectiveness of the system. The larger it is, the more the system will make a profit.

3. As the ratio of profitability to risk, showing the stability of profit that we expect.

 

There are many shades, but it comes down to one idea:

Sharpe ratio = (income - risk-free income) / standard deviation from income.

Income. The amount that we earn on investing in an asset over a period of time and with the presence of risk. It can be expressed both in monetary terms and in percentage.

Risk-free income. There are no investment risks, and the profit for the period is very small. For example, a deposit in a bank.

Standard deviation from revenue. The indicator is calculated by multiplying or dividing the square root of quantitative observations. Suppose we have statistics for each day during the year, the investment amount is $ 100,000, the daily deviation is 1% or $ 1000. If you remove holidays and weekends from the calendar, you get about 250 working days. Round the square root of 250 and get 16. That is, if the daily deviation is 1% -1000 $, then the annual 16% -16000 $.

When calculating the Sharpe ratio for values, you need to take the same time periods, use or express the percentage to percentage ratio, currency to currency. A simple calculation example: (annual income 20% - risk-free 5%) / standard deviation 15% = 1.0.

Even if this indicator is less than unity, then in the long run, you can still achieve good financial indicators. There are indicators that are higher, 5, 10, this means a rapid rise in the market or in the standard deviation the risks were greatly underestimated.

Let's look at the Sharpe ratio on the forex market. In the numerator, income is the profit received for the month based on the strategy of the trader and this will be calculated as the ratio of deposit to profit. The indicator of risk-free income is absent here, which reduces the formula to a simple ratio. In the denominator, our standard indicator is based on risk associated with volatility of pairs. To do this, we need a pair volatility calculator.

 

All this will help the trader to choose a more effective and profitable strategy.

 

Cons of the Sharpe ratio.

1. Sometimes the indicator may not be calculated correctly due to the calculation of profit in percent against the background of the period of loss-making transactions.

2. In the case of a strong fluctuation in volatility, the indicator can give a negative value, which in turn will reduce the objectivity of the coefficient.

3. The coefficient does not take into account the sequence of profitable and loss-making transactions, that is, it ignores the standard deviation.