Let’s take a holistic approach towards Portfolio Management, concentrate on individual positions, and consider the optimum time to enter those positions. We will be looking into the first characteristic of Portfolio Management in this Chapter, namely Sharpe Ratio.
Normally, we look at individual positions, but as we have already seen in early chapters, in order to be a successful trader we also have to know about the direction of the stock and support/resistance levels. How can we build the portfolio in such a way that we can make money irrespective of whether the stock goes up or down, and thus remove the stress related to everyday management of the portfolio?
The only way to do this is to be comfortable with the Maximum Drawdown or the maximum exposure to the market, so that you are comfortable with your portfolio even if the market sells off at 10-20%. We will be going over some of the tools that help you to be comfortable with the Maximum Drawdown on your portfolio.
The first such tool is the Long/Short Equity Fund. It can be defined as a type of mutual fund that mimics some of the trading strategies typically employed by a hedge fund. Unlike most mutual funds, Long/Short funds use derivatives and short positions in an attempt to maximize total returns, regardless of market conditions. The amount of leverage used and the number of derivatives and short positions that Long/Short Funds may contain are limited by law. These funds tent to invest primarily in stocks.
At Tradespoon, we mimic the actions of institutional traders by building a portfolio that has both Long and Short Positions. We use either options or spreads to construct this portfolio. We have also built the Portfolio Toolbox (Figure 49), which gives you an overall characteristic of the Portfolio. These tools will address questions such as ‘How much Exposure you have to the market?’ or ‘What is the Beta, Sharpe Ratio and Volatility of the overall portfolio?’ You can check these numbers to know exactly how much Drawdown and Exposure you are having overall, and make sure that you are comfortable with this Exposure to the market.
Understanding Sharpe Ratio
Sharpe Ratio can be defined as the measure of a portfolio’s excess return relative to the total variability of the portfolio. Using the Sharpe Ratio is one way to compare the relationship of Risk and Reward in following different investment strategies. A strategy with a higher ratio is less risky than one with a lower ratio.
For example, you may have seen lot of advertisements in the market claiming that you can make 100% return in 2 days, or get a return of $10,000 on a $100 investment within two days. Without going into the plausibility of such claims, we can say that you can make a 100% or 200% return on your investment within mere seconds or days, provided you are willing to take high risk.
But how can you get a higher return with lower risk? This is what Sharpe Ratio is all about: The idea of restructuring your portfolio in such a way to maximize your return by limiting the risk. This means limiting the number of high Beta and higher volatility stocks, and maximizing the return.
The idea is to see how much additional return you can get for the additional volatility of holding risky asset over a risk-free asset. For this you have to compare each of the individual positions of the risk-free asset in your portfolio to your baseline, and find those stocks that have relatively low volatility to the baseline but give you the highest return. The higher the ratio, the better it will be.