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Sharpe Ratio Ranking System to Lower Trading Strategies Volatility
The Sharpe ratio is certainly the most popular measure of the performance of investment strategies or trading systems. It is a measure of the risk premium or excess return per unit of risk. It is calculated by subtracting the risk free from the portfolio's return and then dividing the result by the portfolio's volatility, often calculated as the standard deviation.
One of the main advantages of the Sharpe ratio is its ability to produce a measure of a portfolio that takes into account both return and risk. It is also popular because of its capacity to compare different portfolios performance.
The main problem with the Sharpe ratio is that it cannot be used to compare portfolios that have negative Sharpe values and thus it isn't of great help in period of declining markets.
The Sharpe ratio was developed by William Forsyth Sharpe. He used this metric to rank different stocks and then build a trading system that buys the top X securities with the highest Sharpe ratio.
The same idea is used in this trading system. The system doesn't contain any trading rule (you will have to provide your own buy and sell rules); however it contains a ranking system that sorts stocks according to the Sharpe ratio of their close price during the last 60 days. This value can of course be changed (You can set it to the annualized Sharpe ratio for example) and optimized.
For each trading period, buy signals will be ranked according to the Sharpe ratio of the signal's security.
By applying the ranking system to one of my portfolios, I was able to increase the overall trading system's return and decrease its maximum drawdown. The strategy's Sharpe ratio increased mainly because the portfolio's volatility has decreased.
The ranking system that is applied to the trading strategy contains the vector-based "Sharpe" rule.
Other strategies' metrics, such as the Treynor ratio, Jensen's alpha, Calmar ratio, Sortino ratio can also be used to rank stocks in order to reduce the volatility of your investment strategies.
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