My answer to How do i improve the sharpe ratio of my trading strategy?
Answer by Laurent Bernut:
Reverse engineering Sharpe ratio is the trademark of some very large shops, with a large pension fund clientele… Like diet, it is simple in theory but not easy in practice.
How to boost Your Sharpe
The basic idea is to generate consistent returns however puny and then magnify them through leverage. Here is how it is done step by step:
- Collapse volatility: only one way to do it, collapse net exposure (Long -Short market value) to a band +/-10%. That is tantamount to market neutral. Few strategies can achieve this.
- The most common way is pairs-trading. This has built-in market neutrality, but some unpleasant side effects such underwhelming returns and left tail risk
- Another way to achieve low net exposure is to run series not on absolute but prices relative to the benchmark. The long book outperforms while the short book underperforms. It then becomes a matter of controlling net exposure. This reduces the correlation risk
- Generate low volatility consistent returns: returns can be nanoscopic, it does not matter, as long as they are positive. Consistency matters more than quantity because the denominator is a function of volatility of returns , i-e consistency
- Leverage up: if your net exposure is +/-10% and your returns are consistently positive, then You happen to have a low apparent risk profile. So, your prime broker will be willing to extend your leverage. Now, if you clock +0.20% at 200% gross exposure and your PB accepts to lend 4 times, you could wake up with consistent +0.80% per month. times 12 and before You know You will be on the cover of magazines
- Very important: Read this
- Pairs trading has a nasty side-effect that few people are aware of. It is essentially a mean reverting strategy. It works very well until it blows-up. It does not need to blow up “a la LTCM”. It takes a loss of 3-4% in one month and a full year to recover
- Most market participants do not understand Sharpe ratio. They assimilate volatility and risk. Volatility is an expression of uncertainty. Risky strategies are not necessarily volatile, they have open ended risk like short Gamma strategies
Sharpe ratio is part of the Modern portfolio theory package. This dates back to one of the major crimes against humanity of the otherwise barbaric XXth century: the year the US army drafted Elvis. Doctors prescribed pregnant to smoke cigarettes to calm anxiety back then… Maybe it is time we upgraded our repertoire