3 reasons why I don’t use Jensen’s alpha or Sharpe ratio for my forex trading

As a part-time trader, measuring my monthly trading performance can be as simple or as complex as it can be.  On a scale of 1 to 10, 1 being just reading the percent return from the account statement and 10 being running a statistical analysis, my preferred trading performance measurement method is a simple 3.  I am lazy but want a metric that is useful for monthly self-evaluation.  That is why Jensen’s alpha or Sharpe ratio have appealed to me.

Both of these ratios are can be easily derived.  However, 3 shortcomings of these metrics made me decide not to use them for my forex trading.

First is the fact that they emphasize excess return with respective of the market.

It makes sense to compare a portfolio with the overall market on a long term basis.  But what if you want to do month-by-month, or even week-by-week analysis?  Short-term market volatility could skew your performance metric up/down even when you have been performing consistently.  Furthermore, what if it is an out-right bear market?  Your short-side strategy would be boosted by the negative return of the market.

For a swing trader such as myself, a shorter time-frame and long/short unbiased measurements are non-trivial matters for analysing trading performance.

Secondly, neither metrics factor in volatility of a market.  A 5% return in a calm market is not the same as 5% in a volatile market.  If you go out to fish in a storm, you’d better expect a huge payout to compensate for the extra risk.

Lastly, I don’t like their definition of risk.  For me, a short-term performance ratio can sufficiently be characterized as reward / risk.  Jensen’s alpha calculation has no explicit measurement of risk at all.  Whereas Sharpe takes the standard deviation of the portfolio’s return as the risk value.  For a monthly analysis, I would have to use a daily or weekly drawdown to calculate the standard deviation.  The problem with using the daily is that it’s too much work for me to do manually on my spreadsheet.  As for the weekly, having just 4 weeks in a month is not a sufficient sampling size to calculate a representative standard deviation.

In summary, here are my 3 reasons for not using Jensen’s alpha and Sharpe ratio.

1. Emphasis on excess return with respect to the market
2. No consideration for volatility of the market
3. Not agreeing on their definition of risk

On the other hand, there are numerous reasons why these metrics are the standard portfolio measurments used by many traders.  Heck, Jensen’s alpha and Sharpe ratio have been around for 40 years and are still widely in use today.  However, they are just not suitable for me as discussed.

The thing is, there are countless number of new and old portfolio measurements out there.  What one chooses to use depend on various factors such as your style of trading, your agenda, and your interest in this topic.

In my next post, I will introduce the metric that I use for my monthly trading performance analysis — a modified Sterling ratio.

Related posts:

1. Analysing monthly forex trading performance in changing market conditions
2. October 2009 Trading Performance Review
3. June and Second Quarter 2010 Trading Review
4. November 2009 Trading Performance Review
5. Is a $5000 Questrade TFSA trading account cost effective? – Part 3