The Sharpe Ratio - a reliable tool to assess the effectiveness of strategies, assets and PAMM-accounts

The Sharpe Ratio is one of the most common indicators on the foreign exchange market, which can be used to determine the effectiveness of both a single trading strategy and an investment portfolio.

Sharpe formula

The universal assessment of trading strategies is considered to be the ratio of income from trading operations performed within the framework of the strategy, and the risks taken by the trader within the framework of the same strategy. The Sharpe Ratio is an expression of this ratio, respectively, the higher it is, the more effective the strategy used.

The Sharpe Ratio is calculated using the formula:

At first glance, the formula seems quite complicated, but in practice it is much easier and clearer. The numerator of the formula is the amount of average trading income for a certain period. It should be noted that the calculation does not take into account the amount of income received from risk-free assets (bank deposits, etc.).

The denominator is the risk indicator, which is the average deviation from the average rate of return. The risk is in direct dependence on volatility financial instrument.

As a result, by doing the division, we get the Sharpe Ratio. If the coefficient is below zero, it indicates that the efficiency of the asset is extremely low.

If the Sharpe Ratio exceeds the value of 1, it is regarded as an indicator of positive performance. Nevertheless, the author of the formula recommends taking a number around 2 as the optimal value of the coefficient. It should be noted that such assets are extremely rare in the market.

Evaluation of strategies

When calculating the Sharpe Ratio for the strategy, the risk-free income, of course, is automatically excluded, because of its absence.

We take the information on the results of trading operations from the "Report" tab of the MetaTrader 4 trading terminal. We need the average return as a percentage of the initial deposit for the required analysis period.

Next, we determine the amount of risk, which is the average value of the volatility of a currency pair or other financial instrument. The average volatility of a particular instrument can be found using any online service or a volatility calculator.

Divide the rate of return by the risk indicator, we get the Sharpe ratio.

The Sharpe Ratio is a convenient way to compare the performance of the two systems. If both strategies have the same returns, but the risk score is higher for the first strategy, then the Sharpe Ratio of the first strategy will be lower, indicating its lower efficiency compared to the second strategy.

Nuances of determining the effectiveness of PAMM-accounts

The Sharpe Ratio can also be used to compare the effectiveness of PAMM accounts. However, it should be noted that there is a certain difficulty: as a rule, profitable managers trade portfolios and do not particularly share information about their composition. Nevertheless, when copying trades efficiency of manager PAMM-account can be calculated, because the user sees all the tools used. In addition, some PAMM-services indicate already calculated Sharpe Ratio of their managers.

Disadvantages of the Sharpe Ratio

The Sharpe Ratio does not avoid certain disadvantages. For example, if trades are executed with low frequency, but have a high level of income, the Sharpe Ratio will be low. The reason is the high average volatility of such income.

Examples are shown in the figures. The first and second strategies have different profitability, and the Sharpe ratio for significantly different.

To summarize, we can conclude that the Sharpe ratio, despite its apparent complexity, is a practical indicator of the effectiveness of strategies and financial assetswhich gives any trader the opportunity to compare their trading system with any other.

With the practical experience of investing in PAMM accounts you can read in this article:
Investing in PAMM accounts in practice: creating a portfolio on 500$