Five Technical Risk Ratios in Forex Trading
EmailMost professional forex traders make use of technical risk ratios in forex trading. There are five types of technical risk ratios, namely:
- Alpha
- Beta
- Standard Deviation
- Sharpe Ratio
- R-Squared
The aforementioned technical risk rations are most commonly used technical risk ratios. The technical risk ratios enables traders to determine the effective level of 'risk-adjusted-return' in a portfolio. The application of the technical risk ratios has gained importance over the past couple of years mostly due to the volatility in the financial markets which eventually prompted the traders to look towards more effective risk management solutions.
To effectively calculate the specific returns of a trading portfolio, defining the market movements, and the attributed risk to performance is of high importance. Each of technical risk ratios can be applied to effectively analyze a specific holding or segment within the portfolio.
Alpha Technical risk ratio
Alpha is a key technical risk ratio which defines the under performance of a portfolio in relation to a defined benchmark. The Alpha technical risk ratio provides the trader with an objective level of risk adjusted return and highlights whether or not the portfolio manager has been able to beat the market.
For example, if a fund had a net return for 12 months of 12%, and the benchmark index (ex: DJI) only returned 9%; the Alpha would be 3% for that period. The difference in the two figures accurately assesses how well the portfolio manager reacts to the markets.
Beta Technical risk ratio
The Beta technical risk ratio is an essential element of the volatility analysis within a portfolio. The beta technical risk ratio highlights the reactions to changes in market conditions based on volatility and price movements thus grading a security between beta -1 and 1.
For example, if a stock had a beta grading of 1, then the stock follows the reaction of the markets. When an index rises by 2%, the stock also experiences a similar upward shift. The beta technical risk ratio can be used alongside the R-squared technical risk ratio. If the R-squared reacts in negative to thhe market reaction and falls below 70, then this drop impacts the validity of the beta technical risk ratio.
R-Squared Technical risk ratio
R squared is a widely used technical risk ratio especially in modern portfolio theory. R-Squared technical risk ratio is defined as a degree of correlation between the movements of the security, funds and the index. The R-Squared ratio is used to measure the level of under performance of the portfolio.
For example, a fund that has a high R2 implies that the performance could be attributed to the returns in the market. If a fund has an R2 below 70, then it would'nt be attributed to the returns in the market. As mentioned in the Beta technical indicator, the R-Squred works in conjunction with the Beta technical risk ratio and can be used for confirmation purposes.
Sharpe Technical risk ratio
The Sharpe technicak risk ratio is defined as the degree of a risk a portfolio takes in relation to the risk-free rate. The Sharpe Ratio makes of an essentially important measure within the fund management circles. The Sharpe technical ratio allows the trader to analyse each position or trade to ascertain the level of risk in relation to the performance.
For example, a fund that underwent huge losses as well as gained huge profits tend to display a similar sharpe ratio, rather than that of a fund that has significantly higher probability of profits. The target level for most fund managers is a sharpe ratio above 2.
Standard Deviation Technical risk ratio
Standard Deviation technical risk ratio identifies the movements away from the mean or average. The standard deviation of returns offers the analyst a specific illustration on how performance was achieved.
For example, if a fund goes through trade returns governed by a couple of trades of +10 to -10, then based on this scenario, the standard deviation highlights a specific risk. Investors usually prefer a fund's performance to be governed by a bigger percentage of smaller wins and losses. Standard Deviation is also a key component in calculating the Sharpe technical risk ratio.
