In pursuit of profit, traders forget about such a concept as risk. Question: how to evaluate the effectiveness of the strategy? To compare among themselves the bektest of strategies of one type? But they are all different and such a comparison would be incorrect. Comparison of profits will also not be able to give a complete picture of efficiency – a conservative strategy may be more effective than Martingale tactics, which, with several high-yield transactions, will eventually nullify the deposit. To answer this question, the Sharpe Ratio was developed, which allows you to evaluate the effectiveness of the strategy, taking into account both profitability and risk.
The principle of calculating the Sharpe Ratio
This parameter was developed in 1966, but gained popularity only in the 90s with a boom in the development of stock and over-the-counter markets. The Sharpe Ratio makes it possible to assess the risk level of each strategy by comparing it with the return. For example, if at the same yield for a fixed period of time at 30%, the first strategy has a value of 1.54, the second has 0.87, then the first strategy is more effective.
The formula for calculating the Sharpe ratio is as follows: Sharp = (Rp – Rf) / q. Rp is the return on the investment portfolio (strategy) for a fixed period of time, Rf is the return on risk-free instruments, q is the standard deviation of return. A few clarifications:
- the time interval at which a deal is evaluated, each strategy is different: a month can be enough for scalping tactics, a few years for long-term strategies. Therefore, the time for evaluation is chosen not by the duration of the use of the strategy, but by the number of open positions. How to determine the optimal number of deals for testing is described here;
- Rf for the stock market is the discount rate. In Forex, this indicator is assumed to be zero, but this is not entirely correct. Trader’s money could be invested in less risky instruments and it would be most logical to take into account, for example, the average rate on bank deposits;
- q is the instrument volatility parameter. Calculated as the difference between the price of the asset at the beginning of the evaluation period and the price at the time of its termination. There is another way to calculate it: the average profit value per year is subtracted from the amount of profit in% at individual sites (for example, for the end of each month when estimating for the year). Then each value is squared and the arithmetic average is found. From the result, the square root is extracted.
For the optimal value adopted Sharpe ratio, equal to “1”. If the parameter is greater than “1”, the strategy is considered effective, less than “0” is unprofitable. The intermediate interval is a profitable strategy, but it carries great risks.
The ideal Sharpe ratio cannot be called, but it gives a general idea of the effectiveness of the strategy. Its major drawback is averaging the standard deviation of return. It does not take into account sharp price fluctuations within the analyzed interval. If, under the influence of the fundamental factor, the price drastically subsided, but then recovered again, then the value of the coefficient will show a high effectiveness of the strategy, but in practice the position at the time of the price fall could close by a stop-out. Therefore, the effectiveness of the strategy should also be evaluated by the maximum drawdown.
If you have any questions, ask them in the comments.