Today's Quote: “The happiest people are those who discover that what they should be doing and what they are doing are the same thing." Unknown.

We left off with the question, ‘What is a good Sharpe ratio?’ As we alluded, the answer is not an easy one. Some traders may throw out a number like 2.2, or 3.1 or 1.8. Any one of those could be an excellent number. However, a Sharpe of 1 could be excellent also. It depends on the other component, your ‘batting average.’

Your batting average is the percentage of trades that make money. The formula is the number of winning trades over the total number of trades:

number of winning trades
------------------------
 total number of trades

Like all of trading, there are trade offs. It is easy to have a high Sharpe ratio if it comes at the expense of your batting average. This happens when large targets are picked but the quality of the play makes only a small percentage that get to the targets. The reverse can happen also. That is obtaining a fairly high batting average but at the expense of a small Sharpe ratio.

Most traders are guilty of the last one. The reason for this is the eternal fear for most traders of having a losing trade. This makes them take profits early, leading to small but frequent profits. The problem is that the small profits are wiped out by the losing trades. The trader feels good because they are getting lots of trades ‘right’, but they seem to be forever at ‘breakeven’.

So a Sharpe of ‘1’ may not be impressive, but a scalper who gets 65% of the trades right will make serious money at those numbers. As the time frame gets bigger, the Sharpe tends to go up and the batting average tends to go down. Some core traders are very successful with a 40% batting average because they are obtaining a three, four, or five Sharpe ratio. Many intraday scalpers may have a difficult time obtaining more than any "1" Sharpe ratio, but they may be getting way more than half the trades right. The answer will vary with your style, and it is the combination of a good Sharpe ratio with a good batting average that will determine your bottom line. Many traders will actually graph a product of the Sharpe ratio and batting average since they are reciprocal numbers. The higher the overall product the better your trading results will be.

While this may seem like it is simply redundant with the bottom-line dollars you make, it is not. You may be making money but if it is happening with poor "internal statistics" you may find the profits to be short lived. For example many swing traders in the late 1990s were making money, but with terrible statistics. They were simply being carried by a bull market. Once the bull market ended, their statistics told the truth and they had a difficult time trading the market. The types of trades you do, your initial reward to risk ratio, your final batting average and Sharpe ratio are all numbers that should be outlined in your trading plan. The more you plan and compare your results, the better the trader you will be.

For Example:

Trade 1 earns $500
Trade 2 earns $500
Trade 3 has a $400 loss
Trade 4 earns $200
Trade 5 earns $200
Trade 6 has a $600 loss
Trade 7 earns $600

Yields the following statistics:

• Sharpe (Win/Loss) Ratio (rhe average dollar earned divided by the average dollar lost):
     (2000/5) / (1000/2) = 0.8
• Batting Average (the number of winning trades divided by the total number of trades):
     5 / 7 = 0.7143 = 71.43% = 714

Here are some notes to consider:

• A Sharpe of 1.0 and Batting Average of 50% is breakeven.
• A Sharpe of 2.0 and Batting Average of 33% is breakeven.
• A Sharpe of .33 and Batting Average of 75% is breakeven.
• A scalper (shorter-term) trader is likely to have a high Batting Average and a low Sharpe Ratio.
• A Position (longer-term) trader is likely to have a high Sharpe Ratio and a low Batting Average.
• A plot of the sum of these two numbers should be trending up.