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"A lot of folks just look at the return side of the equation," says Wasif Latif, vice president of equity investments for USAA Investments in San Antonio. "But how smooth was your ride to get to that return?" The Sharpe ratio puts those two pieces together. When building a portfolio, the objective is to merge your plan with reality. We want all the return with none of the risk, and it's why a fraud like Bernie Madoff fooled investors for decades. We desperately want to believe in fairy tales, often self-sabotaging our own returns by pursuing unproven complexity over proven simplicity. It's the triumph of hope over experience. For perspective, a Sharpe Ratio of 1 over a long period of time (decades) is extremely rare for any investment or investment portfolio. Just go out and try to find them. Be skeptical of anyone suggesting they can achieve, or have achieved, extraordinarily high Sharpe Ratio's. Here's an example of the Sharpe Ratio of the S&P 500 since 1990: Annualized Return: 9.36% Risk Free Rate (T-bills): 2.87% Annualized Volatility: 14.61% Sharpe Ratio: 0.44 And here's a picture of that reality, from www.portfoliovisualizer.com. One simple way to increase your portfolio's Sharpe Ratio is with diversification. For example, moving half of a portfolio into a bond index fund, and rebalancing annually, has done a nice job of improving your Sharpe Ratio from 0.44 to 0.70 since 1990. Note how much smoother the portfolio growth would have been. Investors would be well served if the finance industry would start showing people a track record instead of simply providing numbers. Just giving investors a bunch of numbers doesn't help them understand the good, the bad, and the ugly of long term investing. At this point, sophisticated investors could get creative and utilize concepts such as synthetic longs with option combos and momentum filters to further maximize risk-adjusted returns, but those are topics for another post and a point to discuss with a competent investment advisor. The point here is to help you think beyond returns to risk-adjusted returns the next time you review your portfolio or a potential investment. The Sharpe Ratio is one proven way to measure how much pain you've historically had to endure in order to achieve a certain gain. Sharpe ratios work best when figured over a period of at least three years, advisers say. Taking our Steady Condors strategy, you might ask yourself: is 17% CAGR (Compounded Annual Growth Rate) a good return? Well, the answer is - it depends. When this return is achieved with only 15% annual volatility - then yes, it's an excellent return. In fact, it is much better than 25% CAGR with 40% annual volatility. Our Performance Page presents Sharpe Ratios for all three our services. We encourage you to check it and compare our Sharpe Ratios to other services (assuming you can even find this info at other services). Related Articles: Are You EMOTIONALLY Ready To Lose? Why Retail Investors Lose Money In The Stock Market Are You Ready For The Learning Curve? Can you double your account every six months? If you are ready to start your journey AND make a long term commitment to be a student of the markets: Start Your Free Trial
2012 and 2013 were in line with our long term profit target of 2-3% per month, but 2014 was a very difficult year for most condor traders. We know many services that actually blew out their clients accounts, but Steady Condors at least was able to limit the losses to reasonable amount, which allowed us to recover from the drawdown within the next 6 months. 2015 was obviously very good, producing 56.5% compounded yearly return. 2014 is the main reason why we are below the long term average. Statistically this not unexpected considering it is only 4 years of data. But Jesse provided a much better explanation: This has been on the FAQ page for quite a long time: How much can I expect to make with your service? Our objective is to make a living, not a killing. We like the story of the tortoise and the hare. Income trading is NOT an ATM machine, regardless of what other option based services are marketing to you. It’s hard and it takes discipline, experience, and a well thought out written plan on how to manage risk. We believe markets aren't perfectly efficient, but they are a lot harder to beat over the long term than most people realize. Our long term goal is to make an average of 15-25% annually on the whole account after trading costs (commissions and slippage). Options inherently provide leverage and substantial risk of loss when not used properly, and iron condors are no exception. Many people mistakenly confuse the high probability of success (per trade) that iron condors offer with safety. Return data is useless without also analyzing risk. I expect SC to have a long-term Sharpe Ratio up to 1 (depending on future risk-free rate which is currently almost zero). Recognizing that this is a topic most people have never been educated on, let me explain. This will help you understand how to more properly analyze returns of different strategies that have different leverage and therefore different risk. A huge mistake that I see retail investors make over an over is only looking at returns. The Sharpe Ratio isn't perfect either, but it's certainly better than only reviewing returns and can give you a way to throw a giant red challenge flag on anyone claiming extraordinary returns. Sharpe Ratio: Annualized return - risk free rate / annualized volatility All you need is a track record of monthly returns to calculate a strategy's Sharpe Ratio. For your reference, 1 is exceptional, and you'll be hard pressed to find hardly any audited track records of any type that have maintained a Sharpe of 1 over a long period of time (10+ years). Yet people are desperate to believe in fairy tales and hope that they've found magic. If a newsletter is honest with you and tells you to "get real", many retail investors will just move on to the next one who will tell them whatever they want to hear in order to gain subscriptions. We'll tell you to get real here. And if you ever feel like we aren't, throw the challenge flag at us. It's why we have forums in order to have discussions. Steady Condors has had a Sharpe Ratio of about 1.3 since 2012 which is above long-term expectations. This is based on 19.8% CAGR (Compound Annual Growth Rate) and 14.6% annual volatility. With the expectations that Steady Condors will produce annualized volatility of around 20% over the long term, this would also land expected returns around 20%. Beware of anything that suggests a massive Sharpe ratio such as 3+ over a long period of time. That would basically qualify them for market wizard status that virtually nobody has achieved for the long-term. Oftentimes you'll find this in a credit spread newsletter where the big loss just hasn't happened yet (it will), or the entire track record is hypothetical, which likely includes overfitting and/or excludes realistic transaction costs. Short volatility strategies like selling options with no risk management can sometimes go for a few years without being tested. Do yourself a favor next time you're looking at a track record and analyze both risk and return, and using the Sharpe Ratio is a great start and a way to possibly save yourself a lot of money. Thank you Jesse for providing such great explanation! At Steady Options, we are committed to promoting long term success to our members which starts with education on having realistic expectations. We will continue telling people to "get real" and not what they want to hear because this is who we are. On a related note, we are one of the few services that report performance on the whole account, not P/L on margin. For example, if we keep 20% of the account in cash and make $400 on $8,000 margin, we would report it as 4% return on $10,000 account. Most services would report it as 5% return. in the long term, it makes HUGE difference. We also include commissions in our reporting, which reduces the numbers by another ~0.3%/month. Always make sure to check how the service reports returns and compare apples to apples. Let me know if you have any questions. Want to learn more? Start Your Free Trial Related Articles: Why Retail Investors Lose Money In The Stock Market Are You Ready For The Learning Curve? How to Calculate ROI in Options Trading Performance Reporting: The Myths and The Reality Are You EMOTIONALLY Ready To Lose?