Forex trading is like a two-edged sword. A few who know and understand the game profit whilst the rest give to the market. They lose their funds and even their entire livelihood to forex trading.
If this is so, how can one stay long and remain successful in this market? Maximizing risk-adjusted returns is one way to. In this article, we discuss the concept of risk-adjusted returns and its benefits as far as forex trading is concerned.
The Concept of Risk Adjusted returns
Risk-adjusted return is a calculation that deals with the potential return investors can obtain on an investment such as a stock or corporate bond when compared to cash or equivalents they engage in. It is usually expressed as a ratio. The higher the values obtained the healthier the investment.
Risk-adjusted returns are also expressed as a comparison between the potential return on an investment to the risk that is associated with such an investment. Many investors are geared towards risk-free investments such as government bonds and Treasury bills, but the returns on such investments are usually low as compared to the fairly, moderately, and severely risky investments. Even now, these government bonds are undergoing haircuts due to the current economic issues most economies in the world are faced with of which some experts of economic issues are attributing to the impact of the Covid-19 and the war between Russia and Ukraine.
In the field of forex trading, the returns on investments are high as well as very risky. Risk-adjusted return is therefore an integral part or element of successful and long-term investment in this market. This practice is often ignored, overlooked, or misunderstood by newbies especially. They mostly see it as important after blowing some substantial amount of money. Risk-adjusted returns are perhaps the most important, least understood part of investing; after all, the return potential of any investment should be viewed in the context of the risks it takes to achieve that return.
Risk-adjusted returns enable the investor to compare high-risk and low-risk investments. With a risk-based approach, you are evolving your process to be one where your first consideration is how much risk you are taking, rather than how much profit you will make day trading. This means finishing each day not counting how much you made but how much you avoided losing! Do that and the profit will look after itself.
Although there isn’t a clear-cut definition of risk-adjusted return, volatility is normally used as a risk to avoid. The reason is simple: you can lose big the more volatile an investment is.
Many disagree on volatility as a measure of risk. However, risk is mostly about avoiding swings in the returns – volatility. But please keep in mind that, for example, Warren Buffett and Charlie Munger argue that volatility is a very poor form of measuring risk. Their logic is that even a sound business is not immune to volatility and might suffer temporarily.
Risk-Adjusted Return Methods
- Absolute Drawdown.
Drawdown in forex trading considers the risk associated with any trading strategy. It is crucial to consider the profitability of any strategy should always be considered vis a vis the drawdown to avoid potential big losses. Since forex trading is a probability trade, the risk/reward perspective must be paramount. The Absolute drawdown is the biggest loss taken below the initial trading capital during a trading session. The Absolute drawdown is calculated as the difference in the trading account capital before and after trading. It is expressed mathematically as:
Absolute drawdown = Initial trading capital – Lowest trading capital.
For instance, let’s assume that the initial trading capital of a trader is $100,000 and the trader experiences a drawdown of $50,000 before making a profit of $20,000.
The Absolute drawdown = $100,000 – $50,000 = $50,000.
After a period of drawdowns, the trader made a profit of $20,000 after the trading session, it means the trader recovered from $50,000 to $120,000.
The risk-adjusted return based on the absolute drawdown is $20,000 / $50,000 = 0.4.
The higher the ratio the better the risk-adjusted returns on that invested via that trading strategy
- Maximal Drawdown
Maximal drawdown is the largest drop in value from a high point to a subsequent low point on an equity chart. It shows how much your strategy can decline after gaining profit and is also known as the depth of a losing streak. It’s advisable to avoid expert advisors with a maximal drawdown higher than their profit. Maximal drawdown is the largest drop in the value of trading equity before a new high is established.
It is therefore expressed as:
Maximal drawdown = the highest value before the largest decline – Lowest value before a new high is formed.
let’s assume that a Forex trader started with an initial capital of $100,000 which increased in value to $120,000, then decreased to $80,000 to begin with. Later, the value of the investment increased to $110,000 before dropping to $70,000. Finally, the value of the investment increased to $150, 000.
The Maximal drawdown = $150,000 – $70,000 = $80,000.
The overallnet profit of the transaction is $150,000 – $100,000 =$50,000.
The risk-adjusted return based on the maximal drawdown is the net profit after the transaction /the lowest value before the drawdown.
The risk-adjusted return would be $50,000 / $80,000 = 0.625.
Again, the higher the ratio of profit vs. drawdown, the less risky is the total gain.
- Relative Drawdown.
Relative drawdown is a type of absolute drawdown only that it is expressed as a percentage. Relative drawdown can be defined the ratio between the maximal drawdown and the corresponding high value of the equity expressed as a percentage.
Relative drawdown = {(Lowest balance value – Highest equity value) / Highest equity value} x100%
Relative Drawdown = (Absolute Drawdown / Initial Balance) × 100%
As an example, if an opened position leads to an increase in the equity to $100,000, before falling to $50,000. The relative draw down is calculated as:
Relative drawdown = ($50,000 – $100,000 / $100,000) x 100%
= ($50,000 / $100,000) x100%
The Relative drawdown = 50%
Many traders prefer using the relative drawdown to create, test and validate trading strategies in determining profitability. Relative drawdown is used a critical stop loss. Anytime drawdowns reach the relative drawdown level most traders close all their trades to avoid margin call.
- Fixed drawdown
A fixed drawdown is defined as the net difference in the equity before entering a trade and the equity after exiting it. It is the total loss experienced after exiting an unprofitable trade.
For example, a trader had an equity of $100,000 before selling GBPUSD but there was a bullish move instead, and after closing the trade in a loss his account balance became $80,000.
The fixed drawdown would be calculated as:
Fixed drawdown = initial equity – Final equity
= $100,000 – $80,000
= $20,000
The fixed drawdown percentage would be expressed as:
Fixed Drawdown % = (Fixed Drawdown / Initial Balance) × 100%
= ($20,000 / $100,000) × 100%
= 20%
The fixed drawdown in Forex is an indicator that shows the effectiveness of a trading system or strategy. For an effective trading strategy, the fixed drawdown should not be greater than 20%.
In conclusion
The aim of a trader should be the saving of his capital first before profit making. Having the mindset of profit-making without considering and managing the risk involved is detrimental to profit-making. A trader must firstly be a risk manager.
As discussed earlier, you can be a consistent profit maker in this market when you observe the necessary risk-adjusted returns modules. Instead of taking abnormal risks which does result in large losses, you will learn to take smaller risks whilst making big and regular profits. Observing these principles will enable you to establish a better risk-to-reward ratio to maximize profit. With time the little accumulation of regular profit will lead to a bigger income. The key to true trading profitably is risk-adjusted returns.
