4.7 Sharpe Ratio - YouTube

In this lecture we're going to be talking about this operation.

So what does the sharp rise in the definition here for a sharp ratio.

Straight from Wikipedia.

Is that in finance.

The Sharpe ratio is a way to examine the performance of an investment by adjusting for its risk.

The ratio measures the excess return per unit of deviation an investment asset or trading strategy typically

referred to as risk.

Named after William F. sharp so the Sharpe Ratio basically permits us to know how much money we're making.

What is the returns that we're making for each unit of risk that we've taken.

Because like we've said you don't the objective here is not only look at returns but look at return

versus risk.

It's very important.

How much risk worth taking.

Now initially when the Sharpe ratio was I guess invented and used was to compare different mutual funds.

You had a bunch of funds.

Let's say you had one fund let's call it fund a.

And then you had another fund fund.

B that gave you a different performance for the year.

So as an investor you don't always know which fund you should invest in.

Right.

For example let's say the first fund here gave us at the end of the year

give us maybe I don't know let's say 50 percent return

rate and then you had to fund B that give us maybe 20 percent return.

So fund a versus fund B now which portfolio or which fund should you invest in.

You know if you just look at them like this maybe somebody's going to be like hey I want to invest into

one that was able to generate 50 percent prefer but the problem here is that this fund took on a lot

of risk.

You see all these drops here.

Imagine this fund had drops of 40 percent rates huge drops.

Well the problem with a fund like that is if you invest at the wrong time imagine you invested here.

Well you'd have lost a lot of money.

Right.

And the potential for you to invest in dropping a lot is high because it does it is very volatile.

But this fund for example maybe the drops that it had was were very small so yeah even though it gave

you less return it was taking on so much less risk that that return is actually amazing compared to

the risk that it's taking.

For example imagine imagine this one has a volatility level because this is where volatility comes in

one to not only look at the the end result but the deviation of the returns throughout time.

So how volatile are these returns.

And we already learned what we use for volatility rates.

We use the standard deviation so imagine that the standard deviation in this fund when we compute it

it gives us something like let's say 40 percent so the Sharpe ratio is going to be calculated by looking

at the return divided by the standard deviation.

So if this one gave us 50 percent return.

But the standard deviation of the returns is 40 percent.

Then it gives us a sharper ratio of one point twenty five.

Now this one imagine the Sharpe ratio here is while the return was 20 percent divided by the standard

deviation maybe the standard deviation here is only optimal for so 20 divided by four.

That gives us five a sharp ratio of five.

What does that mean.

That means that this fund for every because it's five over one rate we removed the one because it's

one.

This This means that this one is giving us five percent return for every unit of risk that it's taking

every 1 units and this one is giving us one point twenty five percent return for every unit of risk

that it's taking.

So this one for the same amount of risk.

This one is giving us way much more return.

So this is the one we should invest in right.

Because we are smart investors trader we look at risk because risk materializes.

Don't ever forget that that risk materializes.

People tell you take risks but you have to understand that in trading risks will happen because you're

trading often.

So you don't want to take unnecessary risk.

So this is where you would invest in this.

This is how people used the Sharpe ratio for mutual funds right.

They had a bunch of different mutual funds and by looking under Sharpe Ratios they would be able to

know which in which they would be able to compare funds with one another.

OK.

Now where the actual function of the Sharpe ratio they usually remove the risk free rate here but we're

not going to do that because we're trading and in trading we don't care about the risk free rate is

so it's so minuscule that it's not worth it.

But we do it a bit difficult so let's come back here and look at the Excel sheet that we've had before.

OK.

We've had this now what I would like to do is actually calculate the sharp ratio for these strategies.

Right.

I want to know what the Sharpe ratio is to know which strategy is better.

Well how would I do that first.

I have to look at the average daily return average daily return.

OK well let's check it out.

Average I can just average these.

I can already tell that the average is going to be two point one percent because the total return is

21 percent.

And we have 10 trades so it's two point one twenty one divided by 10.

And here the average return is going to be the same thing.

Now what I want to do is now already I see that destroy strategies give me exact same returns but the

volatility is not the same.

We know that this one is way more volatile because of these two the two only different trades are these

ones where these ones are way more volatile even though that these two trades together minus one plus

to give us 1 percent and minus twenty one plus twenty two gives us the same thing 1 percent.

So even though the return is the team there were more volatile more risky.

So we need to calculate the standard deviation and this when you just use the function standard deviation

for a sample and we just selects these data points.

And here we go.

We have a standard deviation of six point four five percent.

And here the 10 divisions are obviously going to be higher.

Here we go almost twelve percent.

So way higher.

So now what we want to do is calculate the Sharpe Ratio.

So the Sharpe ratio is going to be the leader turn divided by standard deviation times since earlier.

And you know the Sharpe ratio was used to.

It was used for yearly that you looked at a year's worth of data you looked at the return and the Center

edition for each year.

Now since we're looking at daily data what we need to do is annualized those returns.

Now if you're trading stocks you have to multiply by the square roots and we don't need to get into

the math the square root of two hundred fifty two because that's number of trading days in a year.

But since we're trading crypto currencies and true crypto currencies trade every day of the year we

annualized by multiplying times the square root of 365.

And here we go.

We have a sharp ratio here of six point two.

And here you guys can guess the sharp ratio is going to be less since the standard deviation is bigger

than the same number divided by something bigger than any of us a smaller number which is three point

three.

So I have a sharp ratio that is way better for district.

That means that this strategy generates for me you know a bigger amount of return for one unit of risk

than this one does.

So I would choose this strategy to run because you have to understand that when you're comparing strategies

OK we're even traders.

You want to look at the whole picture.

So for example I've had a bunch of people when they used apply to empty due to trades and some people

would send me the results will be like hey I made a hundred percent return and the last you know whatever

few months.

I'm like Okay well what is your Sharpe ratio.

I didn't know about it.

And when somebody doesn't know about sharpish I don't even continue with the conversation because I

know that they don't understand risk correctly.

So for each firm that I've ever worked at we always looked at the sharp ratio and because a firm would

always prefer something like this that something like that because imagine this imagine I think this

guy if I have two people who who showed me these results for their historical trades 100 percent of

the time I would choose this guy.

Why because I can give this guy three times more money or let's say two and a half times more money

and he would be able to make the same 50 the same amount of money as this guy.

Right.

I could just kill him and give him more capital and he would make the same amount of money but his standard

deviation or his risk would still be lower than this guy who is so volatile.

So we always look at that professionally in any firm you're going to look at that and it's for a reason.

So with the Sharpe Ratio you're going to be able to compare different strategies with each other see

what strategy you should not trying at all which strategy you should put more capital and funding more.

Which strategies you should just paper trade until they have a good enough Sharpe ratio to be implemented.

And yes that's it.

So in the next lecture is going to look at historical trades and how to actually get these numbers for

yourself from your historical trades.

So two guys in the next lecture.