"Time will change and even reverse many of your present opinions. Refrain, therefore, awhile from setting yourself up as a judge of the highest matters." Plato
SafeMoneyMetrics® easily integrates into an investment selection, portfolio construction and monitoring process. This article focuses on the volatility relative to realized ratio used by SafeMoneyMetrics®
Definitions:
After an account starts trading data for the Volatility/Realized ratio is easily available. When selecting an investment, you would need access to past data.
Volatility Ratio: Formula = unrealized profit or loss/margin or capital at risk. For single advisor accounts, the unrealized value can be for the composite account or each market within the entire account. For multi-advisor portfolios, start with the composite portfolio, then each account traded by each advisor. See Client Risk Management services. Custom analysis can then evaluate each market traded by each advisor.
Realized Ratio: Formula = realized profit or loss / margin or capital at risk used to generate that value. The application for the realized ratio is identical to the volatility ratio defined above.
Net Ratio: Formula = realized and unrealized profit or loss/margin or capital at risk used to generate that value. The net ratio application is consistent with all ratios.
The Net Ratio quantifies an advisor’s net realized and unrealized trading performance with respect to the amount of money used for margin. It reveals those traders who use the least amount of capital to produce greatest profitability. By comparing the SafeMoneyMetrics® Net Ratio with the advisors composite rate of return we can even differentiate between advisors showing similar returns. Look at SafeMoneyMetric®s CTA Rankings.
We applied a standard deviation of the volatility ratio relative to the realized ratio: It is called the
Reward to Variability Ratio (RVR): Estimates the ability to produce realized profits with respect to managing the risk of open trades. Traditionally the RVR is calculated by dividing the Risk Premium (RP is a return above the risk free ROR) by the Standard Deviation (SD) of returns. Since SD measures volatility and RP measures risk premium, the result is a risk/reward ratio. We divide the Realized Ratio by a St.Dev of the Volatility Ratio. (RR/SDVR).
A high RVR indicates a higher return relative to the amount of risk taken. For example Assume the Realized Ratio (RR) = 23%, a Standard Deviation (SD) of the Volatility Ratio (VR) for the same time frame is 30%, then 40% and 55%. 23/30=0.76%, 23/40=0.575% and 23/55=0.418%. As the SD increases or RR decreases the RVR decreases.
This ratio is expressed as one number and is applied to every aspect of analysis, including the comparison of investments. Time frames are variable. It is currently used with Client Risk Management services and custom risk management. Read the CRM PDF demo report for details.
How to Apply the Realized to Volatility Relationship
The Realized Ratio (RR) is a true measure of a trader’s profitability with respect to our capital at risk formula. The Volatility Ratio (VR) measures the fluctuation in open trade equity also with respect to the capital at risk formula. These ratios measure two different aspects of a trading program.
RR – How successful a trader is in entering and exiting trades is immediately reflected in their RR computations. Over time higher RR’s will reveal those traders with greater ability in capturing profits when closing out trades.
VR –The VR measures a trader’s ability to manage risk within their open trade positions. How successful or unsuccessful a trader is in managing open trading positions will be reflected in VR fluctuations. In other words, a more volatile VR will reveal larger risk involved with that particular trader. So rather than looking directly at the VR (chart above), it seems more appropriate to measure fluctuations in the VR by way of compiling a simple standard deviation around the VR figures. Lower standard deviations in a VR will signal a trader’s greater ability to manage open trade risk. (Chart 9c below).
So while the realized ratio measures a trader’s ability to successfully enter and exit trades; the standard deviation of the VR measures an ability to manage risk associated with open trades. We can create a simple Risk to Reward ratio from our two SafeMoneyMetrics® ratios. Basically this risk to reward ratio measures a trader’s ability to produce closed profits with respect to their ability to manage risk within open trades. Like all risk to reward ratios the higher the ratio the better the trader.
Taken from the Client Risk Management demo, the graph above averages trading profits every seven days relative to risk and volatility used to achieve the profits. Optimal risk management conditions are indicated by increased profits (left scale) with a stable or gradually higher RVR (right scale). A declining RVR indicates increased risk. Even with growing profits, a declining RVR suggests that prudent risk management would be to distribute profits and effectively review all indicators presented herein.
Naturally all of the above is integrated with a complete due diligence, analysis of qualitative and quantitative factors that we “can perceive and expect” to influence investment performance in the future.
A Short Introduction to Portfolio Construction
Assume we have successfully completed analysis on individual traders. Allocating assets using degrees of leverage also becomes easier and more accurate. Using SafeMoneyMetrics® described at Analysis ,in the text above and in relationship to traditional maximum draw down analysis provides a relatively accurate view of real account volatility relative to maximum drawdown and potential profitability. Each investment is reviewed at various funding levels using traditional rate of return calculations.
100TI
80-20TISI
100HFOF
80-20HFSI
100SI
2003
31.4%
18.2%
15.7%
10.2%
2.7%
2004
9.8%
6.7%
3.9%
3.5%
2.5%
2005
6.7%
8.7%
6.8%
9.1%
14.9%
2006
9.7%
9.2%
6.4%
6.8%
7.8%
2007
5.2%
6.3%
10.4%
10.2%
9.7%
2008
-32.5%
-24.9%
-19.8%
-15.2%
-4.5%
2009
41.2%
29.6%
9.4%
9.2%
8.7%
2010
-0.6%
0.8%
-0.4%
1.1%
3.9%
Total Return
30.3%
24.2%
23.4%
24.6%
33.2%
The table above represents annual returns based on $1000 Unit values invested in a Traditional Index (TI) calculated by equally weighting the S&P500, NASDAQ Composite, Russell 2000 DJIA and a bond index. Then 20% was reallocated to $1000 Unit Values of a portfolio using three advisors. No leverage was used. The Traditional index is before all costs and the SafeMoneyMetrics® Index is after advisor fees and transaction costs.
Each investment is evaluated for its optimum funding level before being integrated into the advisor mix. The total investment is them monitored using Client Risk Management, relative to an internal benchmark.
Investment Monitoring and Reallocation
Ratios are always in one of four positions, always in relationship to each other. A decision is activated based on parameters established by each investor.
- High Realized – Low Volatility
- High Realized – High Volatility
- Low Realized – Low Volatility
- Low Realized - High Volatility
The exact analysis is applied to composite and single advisor investments. - If data moves into a High Realized – High Volatility or Low Realized and High Volatility, risk is probably increased.
Applying the exact analysis to individual traders, or individual markets, we can isolate the weakness. Using short term time frames, we can probably get early warning of possible losses. Short term data is sensitive, a useful timing tool and should be used with a backdrop of longer time frames. You can identify a weakness and adjust the capital allocation. When those particular market conditions prove to be more encouraging relative to an advisor’s strategy the ratios will move into a more favorable position.