The trader’s Catch 22 is that high risk can lead to high returns. Oh, and high risk can also lead to devastating losses.
But the great trading dilemma is to figure out how much return you’ll receive for the risks you take. One way to estimate this risk-reward ratio is by using the Sharpe ratio.
The Sharpe ratio is named after Nobel-prize winning economist William Sharpe.
The ratio is calculated by subtracting the risk-free rate – such as that of the 10-year U.S. Treasury bond – from the rate of return for a portfolio and dividing the result by the standard deviation of the returns.
This may sound a little complicated, but compared to other ways of determining risk, the Sharpe Ratio is a snap.
You might not be interested in calculating the ratio. Many portfolios or Automated Trading strategies display their Sharpe ratio. But, to give you some clearer insight, a ratio of 1 or better is considered good, 2 and better is very good, and 3 and better is considered excellent.
Obviously, the Sharpe Ratio isn’t bullet proof. An asset assigned a lower Sharpe ratio can go on to perform without any volatility; one that is ranked high can blow up.
But there are some advantages.
The Sharpe ratio’s biggest advantage is you can determine it from a series of returns without any extra information about the source of profitability. The one criticism against the Sharpe ratio hits at how returns are distributed–usually in Bell curves. This mathematical convenience edits out “black swan” events (highly volatile moves) and can produce false assumptions of risk.
Unfortunately, these critics haven’t really produced any solid measure of risk on their own. So, the Sharpe ratio, for its fault, is what we have.
If you want to read more about the Sharpe ratio, you can check out Investopedia.