The problem is that due to various issues (some profound and some hidden) this annualization method has very serious problems and it doesn‘t provide meaningful results. The annual Sharpe Ratio is usually way different from the annualized one provided by the square root rule. The same holds for the Sortino Ratio too. Annualization of both metrics therefore should be generally avoided.
SHARPE VS. SORTINO – WHICH GAUGE IS THE BETTER CHOICE?
What is a better Reward/Risk gauge to use when comparing trading systems? Well, even assuming that “risk” for you doesn’t just mean instability in performance but it means “risk of losing money”, the Sortino Ratio is not the definite answer to this question as the better gauge depends heavily on the systems’ goals and idiosyncrasy.
Suppose for example that you want to gauge the Reward/Risk profile of a system whose goal is to earn relatively steady profits over time. This means that the system is designed to crunch short term price moves and it doesn‘t try to capitalize on extreme situations. As a consequence, any extremely profitable trade (although pleasant) is most probably attributed to good luck during for example a strong trend. Next time the same strong trend appears, the system may (due to bad luck, this time) have an opposite position thus producing a significant loss. In effect, high upside or downside volatility for the historical performance of this system is indicative of the system’s inability to stay away from extreme situations even though it is designed to avoid them. This is a case (and you will encounter many such cases when you perform optimization of a system’s parameters) where both high upside and high downside volatility in the historical performance of the system are not welcomed so the Sharpe Ratio is a better gauge of Reward/Risk than the Sortino Ratio for this system.
- The Sharpe Ratio should be preferred if the stability of the equity curve is the focus.
On the opposite, consider a system which targets strong swift directional trends of the underlying and tries to capture as much profit as it can from them. In this case it is only the downside volatility in performance which determines the true risk of losing money for the system because high upside volatility is exactly what the system is trying to achieve. So, the Sortino Ratio is a better gauge in this case.
- The Sortino Ratio better suits to strategies which target high upside volatility of equity curve (like the trend following strategies).
This short explanation gave you the essential difference between the Sharpe and Sortino Ratio and it also gave you ideas regarding what to take into account before choosing the one ratio over the other to rank your trading systems. In the next step we would like to present you how to apply the Sortino Ratio Indicator in Tradesignal.
THE SORTINO RATIO INDICATOR – CALCULATING AND PLOTTING IN TRADESIGNAL.
While almost any trading analysis software provides Sharpe Ratios, the Sortino Ratio is not so popular. Tradesignal offers the facility to calculate the Sortino Ratio for a trading strategy and plot it as an indicator (namely: Sortino Ratio Indicator or SRI for short) to show how the Ratio evolves along with the equity curve of the strategy over time.
A workspace including this indicator can be downloaded.
The Sortino Ratio Indicator has following important parameters:
- 01. Capital
This is the initial capital used by the trading strategy. The default value for the Capital parameter is 100000.
- 02. SortinoPeriod
This is the period of the Sortino Ratio in terms of the period of the chart the system is applied. For example, if the strategy is applied in a daily chart and you want the annual Sortino then this parameter could be set at 252 (since a year is approximately 252 trading days) whereas if you want the monthly Sortino you can set it at 21 (since a month is approximately 21 trading days). As another example, if the system is applied in a weekly chart then for the annual Sortino you can set this parameter at 52 and for the monthly Sortino you can set it at 4. The default value for the SortinoPeriod parameter is 21.
- 03. PeriodsBack
This input determines how many SortinoPeriods back should be taken into account to calculate the Sortino Ratio. If for example you calculate the annual Sortino and this parameter is at 4 then the calculated annual Sortino Ratio will be based upon four years of historical annual returns. The PeriodsBack parameter can be -1 or any positive integer greater than 3. By setting it to -1 you instruct Tradesignal to calculate the Sortino Ratio taking into account all loaded bars history in a chart. The default value for the PeriodsBack input is 10.
- 04. Smooth
Setting Smooth to FALSE will calculate the raw Sortino indicator whereas setting it to TRUE will calculate a smoothed version of the indicator. The default value for the Smooth input is TRUE. The necessity to use a smoothed Sortino indicator stems mainly from the fact that the raw Sortino can be (and usually is) extremely volatile and erratic because the denominator in its formula can be periodically zero or very close to zero. This in turn periodically skyrockets the raw Sortino thus making it practically useless. More precisely, the raw Sortino usually exhibits a recurrent spiking behavior with period equal to the SortinoPeriod (SP) parameter (which, by the way, if you are mathematically inclined you will find it is perfectly normal and expected). You may for example encounter cases where the raw Sortino indicator for a bar is, say, 3 and in the very next bar it flies to 100. The smooth Sortino indicator addresses this problem by taking the moving average of the numerator of the raw Sortino and dividing it by the moving average of its denominator. Both the moving averages are simple and their period is SP.
- 05. RRR
This is the Required Rate of Return for the Sortino indicator. Its default value is zero.
In the following figure the trading strategy “Accelerator” is applied to the Adidas stock. The blue line is the Sortino Ratio Indicator.