How to Measure and Compare Risk Like a Professional Trader
If you go out and ask 100 rookie traders what motivated them to start trading, at least 95% will say to make huge profits. They will talk about the earning potential, how much money they have heard you can make, how they will spend the money (which they have not yet made), and the list goes on. Their clear focus is on returns.
On the opposite end of the spectrum are the people who stay as far away from the market as possible to avoid another R word, risk. They fear they will lose their hard earned money and prefer to hold on to it for dear life in their savings account. The problem is, while the risk is near zero, so is the return. Too little risk is risky.
Successful traders are hybrids of the two people above, and have more than likely started as the individual in the first example. However, to remain successful in the long run we focus more time on analyzing trading opportunities and defining our risks. The returns are our reward.
So next time you hear your friend bragging about his returns, ask him or her the following, “What is your Sharpe Ratio?”. You will essentially be asking them what is their risk-adjusted rate of return. That is, for generating that massive 500% return, what was the risk? Most will not know the answer. But, you need to!
The Sharpe Ratio was developed by William F. Sharpe to measure risk-adjusted performance. It is calculated by subtracting the risk-free rate of return from the rate of return for a given portfolio, then dividing the result by the standard deviation of the portfolio returns. The formula is:
In other words, you are calculating the excess percentage you earned above the rate available if you park your money in a risk free investment, like that savings account. This excess return factor is then divided by how much fluctuation took place in your trading history to achieve these results.
All in all, the Sharpe ratio awards traders who generate excess return and do so with consistency and little volatility in their trades. The traders that win 20% in one trade and lose 80% in the next will not fare well in the Sharpe Ratio test.
Sound like a tedious process? The good news is that we do not have to calculate this manually, and this information should be made available to you by your broker or trading platform. If neither provide this to you, fire them both.
The Results Scale
Once you know your specific reading for a given strategy’s trading results, you can evaluate yourself using the following scale:
- Sharpe Ratios above 1.0 are fair
- Sharpe Ratios above 2.0 are good
- Sharpe Ratios above 3.0 are great
- Sharpe Ratios above 4.0 are amazing
- Sharpe Ratios above 4.5 are what we achieved at our Market Analysis Live webinars (every Sunday at 8PM EST, sign up today for a free one month trial!)
Now that you know about this calculation, if you ever hear another story about someone who started with $1,000 and turned it into a million in just a few months, ask them what their Sharpe Ratio was and compare it to the scale above. I’m willing to bet most will fall far below the 1.0 reading, meaning their results fluctuate so much that their experience was either out of luck or the results are fabricated. I am not saying it is impossible to do, however, for every one person that achieves quick windfall profits, thousands will fail. The few people who actually luck out will found a company and try to sell you a secret system.
At TRADEPRO Academy Inc, we teach you how to approach trading like a business, and to identify and control your risks and manage your profit expectations in a realistic fashion. No systems, no special secrets, because none of that exists. There is no shortcut to success. The quicker you give up the notion that you are lucky and trading is a get rich quick scheme, the quicker you will move to the next stage of trader development.
Good luck and happy trading to all. We wish you trading full of Sharpe results!