Is the Sortino Ratio Useful for Options Trading?
There are many tools that one can use in options trading. One of them helps assess volatility. While volatility is where profits generally lie there are times when excess volatility can be dangerous. A useful tool in checking volatility is the Sortino ratio. This variant of the Sharpe ratio does a standard deviation of negative returns in a portfolio. It starts with the risk free rate of expected return and divides that quantity by the downside standard deviation.
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Sharpe Ratio vs Sortino Ratio
While the Sharpe ratio and Sortino ratio both look at volatility, the Sharpe ratio looks to both the upside and downside while the Sortino ratio only assesses downside volatility. Both approaches use a standard deviation of returns and compare that result with a risk-free rate of return. The main purpose of either of these ratios is to see if assets are performing as well, worse than or better than a cautious, low risk investment.
What Is a Preferable Sortino Ratio?
When the Sortino Ratio is negative that tells you your investment is losing money. Risk is always part of investing and trading. An ideal Sortino ratio is between three and four. From two to three is still good and between one and two is generally considered acceptable. If you are getting a Sortino ratio between zero and one you will want to take a long hard look at your investments because you would be getting a better set of returns from something like a standard savings account at your corner bank! One important fact to keep in mind is that a single bad investment in a portfolio can take the Sortino ratio from excellent to bad. This is the same with options trading where we always remind traders to hedge their trades and not let a single disaster erase the results of weeks, months and years of successful trading. Likewise, this is also a reminder to avoid trading alone in overly volatile markets. While volatility can lead to exceptional profits it can also lead to painful losses.
Calculating the Sortino Ratio
The point of calculating a Sortino ratio is to assure yourself that you are getting the results you want out of your investments. The point is not to learn to do standard deviations or other calculations but to assess the effect of volatility on investment assets. To be useful a Sortino ratio needs to be calculated daily. The point is to have a program calculate your Sortino ratio and compare the results to those of the S&P 500, an inflation-adjusted US Treasury, or a AAA bond (Microsoft or Johnson & Johnson).
If you are interested, here is the formula for calculating the Sortino ratio.
Sortino Ratio = (Rp — MAR)/DDmar Rp is your portfolio return MAR is your minimal acceptable return DDmar is the downside deviation This the DDmar calculation. DDmar = Square root of (1/n times the sum from t=1 to n of min (Rt-MAR),9) squared Rt is the return for day t n is the period considered MAR is the minimal acceptable return
Screening for Volatile Volatility
The value of measuring daily performance is that when you only measure by the month, quarter, or year many of the ups and downs are averaged out. When you follow day by day you pickup the short term, tradable, ups and downs whereas you miss these when you only track on a longer term basis. This is specifically where the Sortino ratio is useful in regard to options trading. The Sortino ratio helps spot problems but it does not tell you how to trade options. For that skill set sign up to join one of the trading squadrons at Top Gun Options where we potentially print money no matter which way the market is headed.
