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The Sharpe Ratio is the first measure I look at when analyzing and assessing a backtest results. It is a simple and quick way to measure the performance of a trading strategy.
While this ratio is often used to measure the excess return per unit of risk of an investment or trading strategy, I am using it, in this trading system, to measure the return per unit of risk (risk premium) of single stocks.
The trading strategy buy rule consists of calculating the 90-Bar Sharpe ratio of a list of stocks and then taking only the top 5 (The five stocks that have the highest Sharpe ratio over the last 90 bars). The list of stocks contains all stocks in the universe that have a close price higher than 2 and a 90-Bar rate of return lower than 50.
In addition, the trading strategy includes a market timing rule that prevents it from taking any position if the average 90-Bar Sharpe ratio of all stocks (>$2) is lower or equal to 0.1. This market-timing rule greatly improves the system performance by decreasing its maximum drawdown to -11.1%, increasing its annual return to 38.26% and its Sharpe ratio to 1.81. The backtest or simulation was performed using a portfolio with a maximum number of positions of 10 and a period that spans from 2001 to 2011 (10 Years of EOD data).
As a sell rule, Sharpe ratio was used again. This rule consists of selling any stock whose 90-Bar Sharpe ratio becomes lower than 0.5. A 50-Bar N-Stop was also added to the trading strategy to allow new winners to be picked quickly.
Trading financial instruments, including foreign exchange on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in financial instruments or foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with trading and seek advice from an independent financial advisor if you have any doubts.
