By Evdokia Pitsillidou, Head of Risk, easyMarkets
The historical volatility of a security, such as a currency pair or stock can be measured by evaluating the performance of the asset. The percentage change on an annualized basis is the most common measure. The volatility of returns, which are positive and negative, is a helpful tool in determining how efficient the performance of a strategy is, and how likely that strategy is to produce outsized gains or losses. The historical volatility of a portfolio can be directly used to calculate future risk by using a number of specific calculations.
The volatility of a portfolio is associated with both positive and negative performance. Historical volatility is calculated by measuring the standard deviation of the performance of a portfolio or asset. There are few robust techniques that can be used by incorporating the historical volatility of a portfolio into specific calculations. Sharpe Ratio, the Information Ration, the Treynor ratio and the Sortino ratio, are just a few.
The Sharpe ration, invented by William Sharpe, evaluates risk adjusted returns by calculating the average return and dividing that number by the historical volatility (standard deviation of the returns).
- Sharpe Ratio = (X – Y) / Z
- Where X = The average return on the portfolio
- Y = Risk-free rate
- Z = Volatility of Returns
The Information-ratio is also an attempt to improve on the Sharpe ratio. The difference within the ratios lies in the numerator which is average return minus a rate. The Sharpe ratio uses a risk free rate while the Information-ratio uses a benchmark that is more closely associated with the portfolio such as the S&P 500 in the case of a long only equity portfolio.
The Sortino attempts to improve upon the Sharpe ratio by removing the penalty associated with upside volatility. The Ratio examines the average return minus the risk free rate of return (identical to the Sharpe ratio) but then divides it by the negative standard deviation, which measures only negative volatility.
The Treynor ratio is a matrix that compares to the volatility of the portfolio relative to its beta. The beta measures portfolios sensitivity to returns. The beta measures the correlation of one security relative to another. The Treynor ratio is very good to use as a tool when adding a stock to a portfolio of stocks.
Although volatility is not the only measure of the future risk of a portfolio it can be an import way to evaluate the potential gain or loss associate with a specific stock or portfolio of assets.