Have you made thirty percent on your forex account last year? – Excellent! The first reply from my side to this good performance would be: “Congratulations!” The second reply would be a question: “What was your sharpe ratio?” An important performance figure in order to compare the “quality” of a return is the so called Sharpe-ratio. This ratio was first introduced to a wider audience in 1966 by William Sharpe. The figure (the higher the better) is used in order to evaluate the risk taken for achieving a certain performance. Let’s assume that two traders both have returned an average of 25 % per annum over the last three years. Trader 1 has a Sharpe-ratio of 1.19 and trader 2 has a Sharpe-ratio of 0.84. That tells you that trader 1 took less risk in achieving the same performance than the risk trader 2 has taken. Basically the Sharpe-ratio tells you if a performance was achieved with smart trading decisions or with excessive risks taken. In order to arrive at the ratio professional traders subtract the risk free interest rate from the annual return of their trading strategy. Usually interest on a ten year US bond is used for this calculation as it is considered to be “risk” free. If a ten year US bond is really an investment without any risk is an entirely different story – let’s assume it is a risk free investment. The current interest rate on a 10 year US bond you can find here. At the beginning of May 2014 this value is roundabout 2.6 % per annum (p.a.). The result of this subtraction is then divided by the standard deviation of the trading strategy. This Standard Deviation (also: “Sigma“) measures the volatility of certain trading strategy. Since this calculation is more complex we are not going into detail here. What you have to know is that the standard deviation (volatility) is very high when you achieve your annual performance with a big drawdown in between. If a trading strategy returns an annual performance of 15 % with a 55 % maximum drawdown during that year that standard deviation part of the formula will be very high and therefore diminishing the Sharpe-ratio. The formula is as follows: (Trading Return p.a. – Risk Free Return p.a.) / Standard Deviation of the Trading Strategy The first part of the ratio (Trading Return p.a. – Risk Free Return p.a.) tells you if it makes sense to follow your strategy in the future or if it would be more wise to invest in ten year treasuries (risk free) instead. If the return of a trading strategy is below the risk free return of a ten year bond for a couple of years in a row it makes certainly sense to stop that trading strategy and invest in the bonds instead. The second part of the ratio gives you information about how that return was achieved. If you have a smooth equity curve with reasonable drawdowns you get a high Sharpe-ratio, signifying that your annual return was achieved with moderate risk. If trading results are very volatile this will reflect in a lower Sharpe-ratio – exposing the higher risk taken in order to achieve that return. Join the Forex Championship Competition today and test your trading strategy!