Why using annualized sharpe ratio?

AI & Machine learning
1

Course Name: Backtesting Trading Strategies, Section No: 7, Unit No: 16, Unit type: Notebook

Hello, tipically people calculate sharpe ratio of their strategies and doesn't annualize it. Why doing that here?

I also noticed the risk_free_rate is annualized as it's divided by 252.

Can you provide a detailed explanation about this?

2

Hello Daniel,



Annualizing Sharpe Ratio is a way to standardise the value and serves a meaningful purpose. The Sharpe ratio is a measure of risk-adjusted return, and annualizing helps in comparing the performance of different investment strategies or portfolios over different periods.



Here are a few reasons why annualizing the Sharpe ratio is significant:



Consistency in Comparison:

Annualizing the Sharpe ratio makes it easier to compare performance across different strategies or portfolios that may have different time horizons. This is especially important when evaluating long-term investment strategies against shorter-term trading strategies.





In the formula, the strategy returns are on a daily time scale, this is why the risk-free rate is divided by 252 to get the daily risk free rate as well. The final sharpe ratio is then annualized.



Risk and Return over Time:

Investors often think in terms of annual returns and annual risk when making investment decisions. Annualizing the Sharpe ratio provides a metric that aligns with this natural thought process, making it more intuitive for investors to assess risk-adjusted returns on an annual basis.



Volatility Scaling:

The Sharpe ratio is calculated by dividing the excess return (return above the risk-free rate) by the standard deviation of returns. Since volatility (standard deviation) is typically measured on an annual basis, annualizing the Sharpe ratio ensures that the risk and return components are on the same time scale.

3

Thanks,



And how do we know when to use annualized sharpe? Only when comparing strategies? What time horizon represents the default sharpe ratio's formula?

4

The annualized sharpe is a standard measure which can be used whenever you want. It's like saying you have received 98/100 in a test, or 98%. Both are equally valid. Ultimately the Sharpe ratio is a measure of risk-adjusted return, and if you returns are in weekly or daily time scale, you can keep the Sharpe ratio in that timescale itself or choose to annualise it, so you can compare your strategy's performance with others, or even when you change the strategy parameters or backtesting period.



Hope this helps.