The Sortino Ratio is a financial metric that evaluates an investment’s return relative to its downside risk.
Unlike the Sharpe Ratio, which considers both upward and downward volatility, the Sortino Ratio focuses only on the negative fluctuations. This makes it a more accurate tool for assessing risk-adjusted performance in forex trading.
The Sortino ratio is calculated by subtracting the risk-free rate from the return of an asset or portfolio, then dividing that sum by the downside deviation of the asset. It was named in honour of Frank A. Sortino.
Sadly, a lot of performance metrics do not take into consideration how different an investment’s risk can be.
Simply put, they figure out their rates of return. This is not the case with this tool. The indicator helps investors make better decisions by looking at changes in the risk-free rate.
In This Post
Why is the Sortino Ratio Important in Forex Trading?
In forex trading, managing risk is crucial. Traders aim to maximize returns while minimizing losses.
The Sortino Ratio helps them identify strategies that achieve higher returns without exposing themselves to excessive downside risk.
By using this metric, traders can make more informed decisions and avoid high-risk trades that could lead to significant losses.
How to Calculate the Sortino Ratio
The formula for the Sortino Ratio is:
Sortino Ratio = (Rp – Rf) / DR
Sortino Ratio = (Average Realized Return – Expected Rate of Return) / Downside Risk Deviation
Where:
- Rp = Portfolio return
- Rf = Risk-free rate
- DR = Downside risk (standard deviation of negative returns)
Assume we’re given the following annual return rates: 4%, 10%, 15%, 20%, -5%, -2%, -6%, 8%, 23%, and 13%.
1. The annual average return rate is 8% = (4% + 10% + 15% + 20% + -5% + -2% + -6% + 8% + 23% + 13%) / 10
2. Let’s say the target or required rate of return is 7%. The additional return will then be 1% (8% – 7%). The value will make up the numerator in our equation.
3. Next, find the standard deviation of downward risks (those with a negative value). We will not consider those with positive returns as their deviations are zero.
Thus, square the downside deviations, then find their average as follows:
(-5%)² = 0.0025
(-2%)² = 0.0004
(-6%)² = 0.0036
Average = (0.0025 + 0.0004 + 0.0036) / 10 = 0.00065
5. For the final outcome, find the standard deviation by getting the square root of the result:
√0.00065 = 0.0255
It gives us:
R = 8%
T = 7%
DR = 0.0255
6. Finally, compute the Sortino ratio as shown:
S = (R – T) / DR
R – T = 1% or 0.01
S = 0.01 / 0.0255 = 0.392
As a rule of thumb, a Sortino ratio of 2 and above is considered ideal. Thus, this investment’s 0.392 rate is unacceptable.
Key Components Explained
Portfolio Return (Rp):
The actual return achieved from forex trading.
Risk-Free Rate (Rf):
The return on a risk-free investment, such as government bonds.
Downside Risk (DR):
Measures only the negative volatility, unlike standard deviation, which accounts for both positive and negative fluctuations.
Benefits of Using the Sortino Ratio
Focuses on Negative Risk:
Unlike the Sharpe Ratio, it ignores positive volatility, providing a clearer picture of risk management.
Improves Decision-Making:
Helps traders identify strategies with higher returns and lower downside risk.
Enhanced Performance Analysis:
Offers a more accurate evaluation of risk-adjusted returns.
Conclusion
The Sortino Ratio is a valuable tool for forex traders aiming to optimize returns while managing downside risk. By focusing on negative volatility, it provides a more accurate assessment of risk-adjusted performance. Understanding and applying this metric can help traders make informed decisions and achieve consistent profitability in the forex market.
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