Sharpe ratio - will help you choose the best PAMM account
Almost every investor who practices PAMM investing is constantly faced with
the problem of choosing between managers who show relatively the same dynamics of profitability and risk over a certain period of time.
The same problematic situation faces traders who decide to choose one of two strategies, which in general show almost the same result, although they use a radically different approach to determining entry points.
The Sharpe ratio was invented by Nobel laureate William Forsythe Sharpe in 1966 to compare the effectiveness of investing investors' funds in certain funds.
This ratio takes into account the expected return of the asset minus the risky return that can be obtained by purchasing government securities, bonds or a simple deposit in a bank.
Now let's understand the meaning of this formula. S is our desired Sharpe Ratio, R is the return of the fund or investment, Rf is the risk-free return on the investment, Si is the standard deviation of return.
Actually, the Sharpe ratio itself doesn’t say much, so it is usually used for comparison with a standard, namely, to compare the resulting number with the same number, but from an investment in another fund.
Sharpe ratio when comparing PAMM accounts
If we talk about the formula that we described above, then practically no one will have any difficulties with calculating profitability indicators, but with the standard deviation of profitability everything is quite complicated.
Actually, when comparing two PAMM accounts, for example with the broker Alpari , you can take this missing number in the characteristics of each manager.
So let's take a simple situation and compare the risk of investing in two different accounts. For example, we will take real PAMM accounts Mikhail B and Uspexx. Both of these traders showed approximately the same returns for the year, which are equal to 36.6 and 36.8 percent.
To compare the two strategies used by traders, we first go to the personal information of trader Mikhail B, where we take the value of the standard deviation of profitability that is missing for our Sharpe formula.
Next, we perform the same action and take for the Sharpe formula the value of the standard deviation from the profitability of only the account manager Uspexx.
And so, let's calculate the Sharpe ratio for the Mikhail B PAMM account. Let us recall that the formula looks like this: S=(R-Rf)/si. As Rf we take an ordinary dollar deposit to the bank, which is equal to 22 percent. Sharpe ratio for Mikhail B = (36.6%-22%)/20.92%= 0.69
Sharpe ratio for Uspexx account = (36.8%-22%)/25.58% = 0.58
If we analyze the results obtained, we can conclude that investing in the PAMM account of trader Mikhail B is a little safer than investing in trader Uspexx.
However, you should also know that if the Sharpe ratio is less than 1, this indicates the ineffectiveness of investing in such PAMM accounts, since it is much safer to make a bank deposit than to take risks for such returns.
Therefore, in conclusion, both of these PAMM accounts turned out to be unsuitable for investment, although at first glance their profitability was attractive.
Sharpe ratio when assessing a trader's trading strategy
When evaluating two trading strategies with almost the same annual return, the Sharpe ratio formula is simplified by an order of magnitude. To begin with, the guaranteed return on investment disappears from the formula, and the volatility of the currency pair also acts as the standard deviation.
So, the Sharpe formula for determining the effectiveness of a trading strategy looks like this: Return for the year in points / volatility of the currency pair for the year in points. The volatility of an instrument in this formula means the distance that the price has traveled in points in one year.
Now, let’s say you earned 600 points using your strategy, despite the fact that the annual volatility of the instrument was 300 points. So, according to the formula, the Sharpe ratio = 600/300 = 2, which indicates the high efficiency of the trading strategy you are using.
In conclusion, it is worth noting that the Sharpe ratio is a simple method to determine the effectiveness of the trading strategy of a PAMM account manager or personal trading strategy based on a simple mathematical formula.