How Can A Forex Trader Use The Sharpe Ratio

Simply stated, the calculation helps investors determine the best place to put money. Before you place money in some investment, you calculate the value of your investment account (including the initial investment plus the profit versus loss) periodically, say, every month. You then calculate the percentage return each month. It doesn't matter what kind of investment you choose. It could be simply buying and holding a single stock, or it could be trading several different commodities or trading various currency pairs with several different trading systems. All that matters is that you want to take into consideration the account value at the end of each month. You will divide the average of the excess returns (the returns generated by the strategy minus the risk-free return) by the standard deviation of the returns and then calculate the average monthly return over some number of months, say, 12 months, by averaging the returns for the 12 months. You also calculate the standard deviation of the monthly returns over the same period. Then you annualize the numbers by multiplying the average monthly return by 12 and then multiplying the standard deviation of the monthly returns by the square root of 12. It seems slightly complicated; but with the help of computers or an Excel spreadsheet, it becomes clear. To further calculate, you need an input value for the risk-free return (Treasury bill rate), which is the annualized return. You now calculate what we consider the excess return, which is the annualized return achieved by your investment in excess of the risk-free rate of return available. This is the extra return you receive by assuming some risk.

It's a way to level the playing field. The Sharpe ratio lets you compare the risk-to-reward profiles of different types of strategies. Instead of trying to figure out if an expected annual return of 40 percent and a standard de viation of 30 percent is better than an expected return of 50 percent with a standard deviation of 40 percent, you just pick the one with the highest Sharpe ratio. The Sharpe ratio will tell you if the returns of one strategy or methodology are due to a better trading ideal or to just getting lucky in a winning streak that has excess risk over a period of time. This measure ment is very useful because although one strategy can make bigger returns than other traders or systems, it is only a good investment if those higher returns are not associated with excessive risk or potential risk exposure in the future based on the performance record of the past. Just keep in mind that the greater a portfolio's Sharpe ratio, the better its risk-adjusted per formance has been.

When trading a forex account that introduces leverage, remember that the Sharpe ratio, which is a tool designed to measure the risk-to-reward ratio, is independent of the leverage. Increasing the leverage increases the risk-and-reward potential on a proportionate scale. In fact, at some point, increasing leverage can potentially decrease the return over time because the amount lost in periods of drawdowns, which could be days, weeks, and even months, may not be made up for several months. So before develop ing, enhancing, or creating your own system, it will help you to understand and run the Sharpe ratio in order to understand the potential risks involved in trading it. As we say in the business, if the risks are not worth the re wards, then don't take the trade.

Review Table 8.1. These are the basic terms to refer to when determining whether a trading system has merits to test with real money, especially when it's your own. Most software companies with back-testing capabilities use these terms. These are considered standard industry terms. The table shows the important ones you want to follow.

Now that we have covered the importance of how and why to analyze a system, I want to disclose a building block or foundation of a system or a concept behind three systems that integrate three popular technical tools with pivot point support and resistance analysis:

Let's start with one of my favorite technical tools combined with pivot points—the stochastics oscillator. This tool measures the strength and the weakness of the momentum in prices. The math formula measures where the close is in relationship to the high, the low, and past closing prices in a given time period. It is very important for you to understand what makes this tool tick, so to speak. The concept is based on the premise that if mar ket prices are bullish, they will tend to close at or near the top of their given range; and if market prices are bearish, prices will close at or near the lows of their respective ranges. This concept is important because as prices near a critical pivot resistance level, we want confirmation of a price re versal to trigger a short. That is what the stochastics does. It will give us a clue as to whether a rally or an uptrend is exhausting itself. If this is true, then the close will not be at the high end of the trading range. For this sys tem, I use the fast stochastic with the 14-period setting for %K and the 3 period averages for %D. This is the normal default setting for most charting software packages. Keep in mind that the results are based on an entirely mechanical trading method. There are no discretionary decisions or inputs, such as selecting which trades to take based on economic report release times or, removing or trailing the stop-loss orders. This system is considered a countertrend trading method; but we are keeping with the golden trading rules for short-term traders, which is to sell resistance and buy sup port. All these systems were run on 15-minute time periods and during all trading sessions, meaning a 24-hour period from a 5:05 P . M . (EST) open to a 5 P . M . (EST) close.

The pivot points were calculated at the 5 P . M . (EST) Bank of New York settlement time. Here are the parameters for the stochastics system sell sig nals, which are programmed to trigger within 10 PIPs (percentage in points) above or below the pivot point resistance 1 (R-1), resistance 2 (R-2), and resistance 3 (R-3) levels; once the stochastics indicator is above 80 per cent, it then scans for a cross-over of %K and %D to occur as these lines close back below the 70 percent level. The testing signals are included at the R-1 level; but the parameters do not define a wide enough price extreme or departure from the means as defined by the typical price or the actual pivot point. When prices have had an extreme price move from the prior session, R-1 would be calculated at a significant enough distance that I would consider a move as being in a short-term overbought state. Once the sell signals are generated and trigger a short position, we use a 100-PIP ini tial stop from entry price with a 40-point profit target. Granted, that is not the optimal risk/reward ratio that is in everyday trading books; however, I selected that risk amount for three reasons: (1) It is approximately 1.20 percent more than the average daily range; (2) in order for prices to reach a daily R-1, R-2, or, for the extreme, R-3 number, prices would tend to be in an overbought market condition and ripe for a price correction; (3) looking at the back-test results shows that the system without risk parameters has an average loss of $884. Therefore, if an unexpected extreme price move occurred against the initial entry, we might escape harm from prematurely being stopped out of the market 100 PIPs further away.

Once prices have expanded and reached an extreme level, such as a pivot R-1 or R-2 price zone and because this is a countertrend trade, I am only looking for a short-term move. Statistically speaking, the average gross win is $808 and the average net profit is $255. If you find the average of these two components, we are roughly at $531.50, which works out to 53 PIPs. I might have a margin of error of 10 percent on entry and exit, which then brings us to a 43-PIP objective; and if there is a 3-PIP spread, we have a 40-point profit target opportunity. As such, the average daily range is near 86 PIPs in the euro. If I capture half of that range on a systematic trading program, the odds favor the market “regressing to the mean,” or re turning to a fair value level. So determining a 40-PIP profit target seemed reasonable.