July 8, 2018
If you've ever landed on our site, or any of the other volatility trading sites, you're probably interested in investments that are riskier than government T-bills. These government T-bills are considered risk free investments; there are no interest payments and there is considered to be no default risk associated with the bills because they are backed by the government. As investors, we are seeking the highest possible return in exchange for the lowest amount of risk possible. Percentage returns on investments are easily understandable to the layman investor: however, measuring risk in your portfolio may be less comprehensible to some. So how do we measure risk?
The Sharpe Ratio
One of a handful of ways to measure risk in a portfolio is to use the Sharpe Ratio. While this may be a fancy finance term used by those in this line of work, it's easily understandable to the average investor. The Sharpe Ratio measures the excess return of a portfolio over a risk-free asset, relative to the amount of risk that is taken on in the portfolio. A Sharpe Ratio of greater than or equal to one is considered to be a good ratio. The higher the Sharpe Ratio the better, as we are generating returns with less associated risk in the portfolio. The equation for the Sharpe Ratio is as follows:
Sharpe Ratio = (Expected Portfolio Return - Risk-Free Rate) /Standard Deviation of the Portfolio
Analogy
Let's take two sailboats (each representing a separate portfolio). Both are sailing to the same destination (this is our expected portfolio return). As a sailor, we want to reach our destination in the safest way possible (sure, there may be some daredevils looking for a rush, but this is beside the point). Ship A will take an easy sailing route full of sunshine and rainbows, while Ship B is taking a less desirable route through raging seas and thunderstorms. Again, both ships are sailing to the same destination; however, Ship B is taking a considerably riskier route, only to arrive at the same place. In the long run, investors want to minimize drawdowns and mitigate risk as effectively as possible, so naturally, smart investors will want to take Ship A over a sea of turmoil. We do not want to be hanging on for dear life as our boat experiences the large swells of the rough seas if there is no added benefit.
Limitations
Perhaps the most prominent limitation we come across in the volatility space is that the Sharpe Ratio accounts for upwards swings in the portfolio. We, of course, want to see our strategies record great months; however, abnormally large returns can hurt a portfolio's Sharpe Ratio. Because the denominator is the standard deviation of our entire portfolio, large upward movements in our portfolio, which in turn leads to a large standard deviation, can end up decreasing our Sharpe Ratio.
We will upload another post explaining The Ulcer Performance Index, another metric used to asses risk but does not account for those good upward price movements in our portfolio.