Forex Funds And The Sharp Ratio

The Sharpe ratio is a measure of risk-adjusted performance that indicates the level of excess return per unit of risk. In the calculation of Sharpe ratio, excess return is the return over and above the short-term, risk-free rate of return and this figure is divided by the risk, which is represented by the annualized volatility or standard deviation.

In summary, the Sharpe Ratio is equal to the compound annual rate of return minus rate of return on a risk–free investment divided by the annualized monthly standard deviation. The higher the Sharpe ratio, the higher the risk-adjusted return.  If 10-year treasury bonds are yielding 2%, and two Forex managed account programs have the same performance at the end of each month, the Forex managed account program with the lowest intra-month P&L volatility will have the higher sharp ratio.

The Challenges of Investing in Emerging Forex Traders

Investing in emerging Forex traders (these traders are sometimes called managers) can be extremely rewarding, or it can be extremely disappointing.  Similar to athletics, catching a rising star before anybody else notices a person’s talents can be financially rewarding for both the discoverer and the discovered.  Generally, as assets under management grow, returns shrink. And here’s the paradox: the longer you wait for a manager’s track record to become statistically significant, the more likely it is that that manager is going to acquire more assets under management and the managers track record will suffer due to the law of diminishing returns.  We all know it is easier to manage a $100 thousand vs.  $50 million.

Investors who take that first chance on emerging trader can make a fortune.  The initial investors in Warren Buffet and Paul Tudor Jones funds are now multimillionaires, or possibly billionaires.  How an investor picks an emerging manager is as much of an art as it is the science.

The art and science of picking emerging managers will be a topic of Forex Funds blog post shortly.

Drawdowns Explained

An investment is said to be in a drawdown when its price falls below its last peak. The drawdown percentage drop in the price of an investment from its last peak price. The period between the peak level and the trough is called the length of the drawdown period between the trough, and the recapturing of the peak is called the recovery. The worst or maximum drawdown represents the highest peak to trough decline over the life of an investment. The drawdown report presents data on the percentage drawdowns during the trading program’s performance history ranked in order of magnitude of loss.

  • Depth: Percentage loss from peak to valley
  • Length: Duration of drawdown in months from peak to valley
  • Recovery: Number of months from valley to new high
  • Start Date: Month in which peak occurs.

The Time Frame of a Forex Funds Investment

Investing in Forex is speculative and tends to be cyclical. Additionally, even the most successful professional traders experience periods of flat returns or even drawdowns. Consequently, those trading periods will suffer losses. The wise investor will remain steadfast in his/her investment plan and not close the account prematurely to allow the account to recover from temporary losses in equity. It would not be a wise investment strategy to open an account that you do not intend to maintain for at least six to none months.

Forex Volatility

Forex and volatility go hand-in-hand.  Forex volatility is determined by the movement of a Forex rate over a period. Forex volatility, or real volatility,  is often measured as a normal or normalized standard deviation, and the term historical volatility refers to the price variations observed in the past, while implied volatility refers to the volatility that the Forex market expects in the future as indicated by the price of the Forex options.   Implied Forex volatility is an actively traded options market determine by the expectations of Forex traders as to what real Forex volatility will be in the future.  Market volatility is a critical component of a Forex traders evaluation of a potential trade.  If the market to too volatile, the trader might determine that the risk is too high to enter the market.  If market volatility is too low, the trader might conclude that there is not enough opportunity to make money so he would choose not to deploy his capital.  Volatility is one of the most critical factors that a trader considers when he is deciding on when, and how, to use his capital.  If a market his highly volatile, a trader might choose to deploy less money then if the market was less volatile.  On the other hand, if volatility is low, a trader might decide to use more capital because lower volatility markets might offer less risk.

Forex Risk Management

Forex risk management is the process of identifying and taking action in the areas of vulnerability and strength in a  Forex portfolio, trading or other managed Forex account product. In Forex options, risk management often involves the assessment of risk parameters known as Delta, Gamma, Vega, Rho, and Phi,  as well as determining the overall expected return per Forex trade in the monetary loss to traders willing to forgo if the trade goes wrong. Having proper risk management can often make the difference between success and failure especially when dealing in the Forex markets.