Being able to understand whether an investment was worthwhile stretches much further than merely calculating the return on investment. What a lot of young forex traders and investors often forget is that investing has two critical components; one is to make money, the other is to prevent losing money. Because of the high level of risk that can be taken on in the FX market, many traders use the Sortino Ratio in forex to compare gains against the risks.
Consider you are deciding between two different strategy providers or expert advisors. You start with an account balance of $5,000 in each trading account, and after a month, there is a profit of $500. Both strategies earned an RoI of 10%. But when you look under the hood, you may see that each system exposed you to totally different levels of risk.
One strategy may have taken many, frequent, small positions and never risked more than one or two per cent of the account balance on each trade. In contrast, the other strategy may have just taken one highly leveraged position and held it open for weeks while it was in drawdown and even came close to a margin call.
Not every investment carries the same level of risk, which is why it’s essential to understand the risks associated with any investment so you can effectively compare which opportunities are worth the risk. Therefore, traders and investors rely on calculations like the Sortino Ratio to be able to understand the risks of different portfolios or strategies.
Introduction to Sortino Ratio
The Sortino Ratio is pretty similar to the Sharpe Ratio, except the Sortino Ratio is far more refined in terms of what it can reveal about risk. In essence, the Sharpe Ratio assesses a few things; profit, volatility (risk), and how much you could have otherwise profited from a risk-free investment, such as government-issued bonds.
The problem with the Sharpe Ratio is that it does not differentiate between good risk and bad risk. The previous statement might seem like an oxymoron, but not all risk is bad. Risk goes hand in hand with investing, so you cannot accurately consider it bad, especially when it leads towards profit.
Good risk is quite simply, risks that are taken and result in gains. Bad risk is risks that are taken but result in losses. The fundamental difference between the Sortino Ratio and the Sharpe Ratio is the former can separate the two types of risk in its evaluation of an investment, portfolio or forex trading strategy.
How is the Sortino Ratio calculated?
The Sortino Ratio confusingly has different methods of calculating it, depending on the context of the investment you are analysing. This is the most common approach for calculating Sortino Ratio in forex.
S = (R – r f) / DR
- R = Return: The average realised return of a forex trading account, portfolio or investment over a period of time.
- rf = Risk-free rate: The minimum amount of profit and investor could make if they had otherwise invested their money in government bonds or fixed income products.
- DR = Downside Risk: The standard deviation of the downside deviation.
Standard deviation vs downside deviation
The principal difference between the Sortino Ratio and the Sharpe Ratio is the denominator used in the formula. In the Sharpe Ratio, the denominator used is the standard deviation, which considers all volatility associated with the investment and therefore, does not distinguish upside and downside volatility or good and bad risk. The Sortino Ratio uses downside deviation, which isolates only the downside, or bad risk.
Why forex traders use Sortino Ratio
The Sortino Ratio offers a significant improvement over the Sharpe Ratio, especially for forex traders. When a trader analyses the performance of a forex trading strategy, rather than evaluate each individual trade, the entire account will be assessed over a certain period.
The very nature of day trading or scalping the forex market with a conservative risk management strategy implies that many positions each day or week will be opened and closed. With a 1-to-3 risk-to-reward policy, a trader can be profitable if only four in every ten trades are successful. As each closing trade realises profits and losses, this technique causes the account balance to fluctuate. Even if the account ends up profitable by the end of the month, the Share Ratio would be unforgiving and consider this strategy as volatile.
As the Sortino Ratio concentrates on the downside risk, the volatility and therefore, the risk that is required to achieve results is not considered; only the bad risk is considered.
Calculating the Sortino Ratio in Forex
Now let’s follow an example of how to calculate the Sortino Ratio of a forex trading account. To perform the calculation, we will need to collect the following values; the return, the risk-free rate and the downside deviation.
Suppose we consider the activity of a trading account from between the 1st of October 2019 to the 31st of October 2020. The trading account in this example is denominated in euros and was funded with €5,000. At the end of the 12 months, the account balance was €7,240.33. Therefore the return on investment is 44.8%.
Currently, the yield rate of US treasures is a meagre 0.12% as of November 13th 2020.
The topic of calculating downside deviation is a subject of its own. Therefore, we will quickly conclude for the sake of this example; the downside deviation was 22%.
- Return = 44.8%
- Risk-free Rate = 0.12%
- Downside deviation = 22%
(44.8% – 0.12% = 44.68) / 22 = 2.03
Therefore the Sortino Ratio of the analysed forex trading account is 2.03.
What conclusions can Forex traders get from Sortino Ratio
The Sortino Ratio is a comparison tool, not a verification tool. What this means is that, if presented with two relatively similar options, i.e. two forex trading strategies, the Sortino Ratio can help you to decide which one generates an appropriate amount of reward for the bad risk that is taken. Therefore, there is no fixed gauge to determine what is and is not a good Sortino Ratio, except, anything below zero is bad.
When you are comparing two or more strategies against each other, the higher ratio suggests a better risk-to-reward investment. As always, no measurement or metric should be used in isolation. There are so many nuances involved when determining the appropriateness of an investment opportunity, and the Sharpe Ratio is just one of many tools available.
Forex trading is an inherently volatile market to trade. Volatility implies opportunity rather than risk. Therefore, using a performance metric like the Sharpe Ratio, which penalises all volatility regardless of whether it is good or bad, doesn’t make a lot of sense. That is why the Sortino Ratio is a practical tool for forex traders.