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Sharpe Ratio
Sharpe Ratio is a measure developed my Prof. Sharpe of Stanford Un.
to measure the worth of any investment. Prof. Sharpe shared the Nobel
Prize in Economics in 1990 for this and his other work in what is now
called "Modern Portfolio Theory". Prof. Sharpe has a paper on it on
his web site (reprinted from the The Journal of Portfolio Management)
at <http://www.stanford.edu/~wfsharpe/art/sr/sr.htm>.
It is defined as:
Sharpe = Annualized_average_return / Annualized_standard_deviation_of_returns -
Interest_on_money_used_in_the_period
(When trading futures, the interest term is zero since the cost of the
interest is built into the price (premium over the price of the
underlying).
It is basically a measure of the risk-adjusted return of an
investment. Return alone is a useless measure since you can increase
the return on any investment by using more leverage (trading more
contracts). The Sharpe Ratio of a trading system is independent of
the number of contracts traded.
Actual measurement is a bit complicated by how you decide to measure
returns and many tools (including TradeStation 2000i) do not measure
it correctly. (I understand that the Rina tools have corrected the
calculation but the new version has not been incorporated into
TradeStation 2000i.)
The Sharpe Ratio of a Buy/Hold strategy on the Nasdaq Composite Index
for the past 30 years is about 0.16.
The Sharpe Ratio of a Buy/Hold strategy on the Nasdaq Composite Index
from the bottom in July 1974 to the top in April 2000 is about 0.54
(perfect long term market timing)
A good money manager might have a Sharpe Ratio above 1.0. Really good
money managers might get to 2.0 or 3.0.
Back in September 2000, before the crash, according to MorningStar:
Only 4% of all mutual funds had a Sharpe Ratio >= 1.0
The Vanguard 500 Index fund had a Sharpe Ratio of 0.87
A "decent" trading system has a Sharpe Ratio of perhaps 1.0 in
backtesting and a very good one, 3.0 or better. I have seen trading
systems with Sharpe Ratios as high as 7 in backtesting. Intraday
trading systems tend to have higher Sharpe Ratios that systems using
daily bars but they require full-time attention so you have to factor
in the cost of your time in making comparisons.
The equity curve of a high-Sharpe-Ratio trading system looks like a
nearly straight line as in the attached GIF. (Sharpe Ratio = about
7). This indicates very consistent returns vs. time.
Keep in mind that the Sharpe Ratio of money managers and mutual funds
is what they actually achieve in real life with lunch breaks,
mistakes, bad data, etc., while those in backtesting are "ideal"
conditions.
K-Ratio
The K-Ratio is a measure proposed by Lars Kestner in an article in
"Technical Analysis of Stocks & Commodities", March 1996, pages 46-50.
I did an extensive analysis of this measure and found that the value
of the K-Ratio seems to depend upon the number of bars used in the
calculation. I sent the analysis to Mr. Kestner and he replied:
>I did get your message - certainly interesting.
>First glance would appear you're right, but I wanted
>to do more simulations to get better insight. Once I
>get past expiration today, I'll have more time to
>focus on this. Frankly, I'm very curious. Thanks for
>bringing it up!
I have not heard from him since so I assume he either agrees or is
too busy to think about it. I do not put any emphasis on the K-Ratio
measurement.
Rina Index
The Rina Index is a proprietary measure created by Rina. The on-line
help describes it.
Hope this is useful.
Bob Fulks
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