Trading System #1–Initial Assessment (Part 4)

Today I will continue to compare the SPY daily long strategy with vs. without an overbought VIX filter by discussing Sharpe Ratio (SR).

The Sharpe Ratio (SR) is one of the most commonly referenced measures of risk/return.  It is calculated as the difference between the average return and the risk-free rate divided by the standard deviation of all returns.

The numerator of the SR describes “excess return.”  The better the average return of the system the greater this number will be.  The sign of SR will be determined by the numerator and any potentially profitable system must have a positive SR.

The denominator rewards systems that have higher consistency of returns.  Typically when a system performs well, positive returns are consistent (e.g. closing at set profit targets).  When the market goes awry for a system, feel lucky if you get taken out at your stop-loss point.  In many cases with violent market moves, a gap may jump far beyond a stop-loss point before the trade closes.  For this reason, more poorly performing systems have a larger variability of returns and therefore larger denominator.

A primer on how to calculate SR with Microsoft Excel is seen here:  http://investexcel.net/214/calculating-the-sharpe-ratio-with-excel/ .

The SR has been highly criticized in financial circles and should therefore be taken with a grain of salt.  For one thing, rewarding consistency of returns (e.g. 2% per month rather than 12% one month and 0% the other 11 months) means short option premium strategies often get high SRs.  Short option strategies have catastrophic risk, however, that many other trading strategies do not (think Long Term Capital Management in 1998).  What is also debatable is that the SR penalizes variability of returns whether that variability is profit or loss.  A strategy that returned 2% in 11 months and 12% in one month would reflect similarly in the denominator as one that returned 2% in 11 months and -8% in one month.

In the current study, buying SPY when VIX is “overbought” results in a much better SR of 0.84 vs. 0.36.  As is often the case with other system statistics, SR is often negatively correlated with exposure.  This means in order to get the desired net profit out of your portfolio, a single highly profitable system won’t be enough.  The goal should be to find multiple systems with large PFs or large SRs to work together.