In the world of investments, specifically, when investing in the digital market, we are influenced by investing decisions of the majority. We let our emotions drive our investment decisions and let rationality take a back seat.
However, when it comes to investment, especially in a volatile market like crypto, you need to know what risk you are inviting before making a trade. Your investment will only be viable if your potential return can outweigh the associated risks.
Now you must be wondering how you can measure the level of risk, keeping in mind your return. Well, the simple key is by finding out the Sharpe ratio.
What Does Sharpe Ratio Mean?
Risk and returns are constant features of the financial market, so is the case with the crypto market. Investors today are too busy focusing on the return on investments that they forget the financial risks that may come along.
Sharpe ratio is one of those significant metrics that help you in analyzing the risks associated with returns. They observe the data and provide you information based on logic to derive your trading strategy by measuring your risk to reward ratio of the strategy.
Overall, the Sharpe ratio weighs the returns on your investment against your volatility.
Why Is Sharpe Ratio Metric Crucial?
Unfortunately, one of the reasons why people suffer huge losses due to unexpected risks is that they do not consider Sharpe ratio metric. Investors are often busy observing other indicators that overlook this metric and pose a considerable danger to their investments.
However, the metric is the easiest and reliable method to find out the risk-adjusted return. You can easily measure return in terms of risk and place a trade based on the results. Then, you will be surprised by the wonders the Sharpe ratio can do for your investments.
Whenever you think of placing a trade or using an investment strategy, calculate the Sharpe ratio. This way, you get to know the long-term viability of your strategy.
From the risk-adjusted perspective, the higher the Sharpe ratio, the better it is for you as an investor.
Simple Way to Calculate Sharpe Ratio
As you know, the Sharpe ratio is used to measure the ratio of the risks of an investment to its rewards. It divides your returns from the volatility. The simple formula is as follows:
Expected return – Risk-free rate / Standard deviation of your expected return = Sharpe Ratio
As an example, say your
Risk free rate = 20%
Standard Deviation = 60%
Then your Sharpe ratio will be 3.
This simple number can decide the success and failure of your investment strategy. Now you must be wondering how this simple number offers you information about your risks on returns – the next section clears this confusion in detail.
Understanding Your Sharpe Ratio – Tips and Tricks
When you calculate through the Sharpe ratio, some investments prove beneficial if your focus is on the stability and the predictability of the cryptocurrency or other asset, despite having a lower rate of returns.
All in all, the higher the Sharpe ratio, the better your investment strategy is. Usually, there are three basic conclusions that you can derive from your Sharpe ratio as a rule of thumb:
Sharpe ratio lower than zero:
If your calculation turns out anything less than zero that either 0.1, 0.2, etc., you will do great if you hold on to the risk-free investment.
Sharpe ratio between zero and one:
If, after dividing the returns and risks, you get a Sharpe ratio somewhere between zero and one, then the investment you are testing has a high chance to do better than the risk-free investment.
Sharpe ratio more than one:
If the calculation gives you a Sharpe ratio that is more than one, then this is good news for you. In terms of risk and return, the investment is going to be a great one.
A Quick Tip: If you are looking for ways to increase your Sharpe ratio, then focus on increasing your return. Meanwhile, do not let your risks increase more than your returns to keep a striking balance.
If you wish to optimize and analyze your trading experience, then the Sharpe ratio is an excellent metric to try. When you derive and backtest your strategies keeping this ratio in mind, you will observe outcomes in the form of returns like never before.