Risk Metrics

Essential Risk Metrics

Understanding risk metrics is crucial for evaluating trading strategies and managing portfolio risk. These measurements help you compare strategies, set expectations, and make informed decisions about your trading approach.

Sharpe Ratio

The Sharpe Ratio, developed by Nobel laureate William Sharpe, measures risk-adjusted return—how much excess return you receive for the volatility you endure.

Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation

Example:
Portfolio Return: 15%
Risk-Free Rate: 4%
Standard Deviation: 12%
Sharpe = (15% - 4%) / 12% = 0.92

Interpretation: Below 1.0 = suboptimal, 1.0-2.0 = good, 2.0-3.0 = very good, above 3.0 = excellent (but verify it's not overfit)

Maximum Drawdown

Maximum drawdown measures the largest peak-to-trough decline before a new peak is achieved. It represents your worst-case scenario and is critical for understanding the psychological challenge of trading a strategy.

Alpha and Beta

These metrics compare your strategy's performance to a benchmark (typically the S&P 500):

• Alpha: Excess return above what the benchmark would predict. Positive alpha = outperformance.
• Beta: Sensitivity to market movements. Beta of 1.0 = moves with market; above 1.0 = more volatile; below 1.0 = less volatile.

Sortino Ratio

Like the Sharpe Ratio but only penalizes downside volatility. Upside volatility (making more money than expected) isn't punished.

Calmar Ratio

Measures return relative to maximum drawdown. Useful for understanding return per unit of worst-case risk.

Calmar Ratio = CAGR / Maximum Drawdown

Example:
CAGR: 18%
Max Drawdown: 25%
Calmar = 18% / 25% = 0.72

What Good Metrics Look Like