In this lesson, we will explore and apply the concept of volatility-adjusted returns specifically to Deriv’s Volatility Indices. Understanding this metric is essential for evaluating your trading performance beyond just raw profits, offering insights into the risks associated with your trades.
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The Importance of Volatility-Adjusted Returns

When trading, it is crucial to consider not only the potential profits but also the risks you're exposed to in order to achieve those returns. Volatility-adjusted returns provide a clearer picture of your trading performance, factoring in the level of volatility associated with your chosen assets. This metric enables traders to compare different strategies across varying market conditions effectively.
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Key Concepts

1. Raw Returns: This term refers to your profits or losses, usually expressed as a percentage. For example, if you invest $1,000 and grow it to $1,100, your raw return is 10%.
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2. Volatility: Volatility measures the degree to which the price of an asset fluctuates over time. Higher volatility indicates larger price swings and thus presents a greater risk to traders.
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3. Volatility-Adjusted Returns: This metric modifies your raw returns based on the level of risk associated with the asset. A commonly used measure for volatility-adjusted returns is the Sharpe Ratio, which is calculated as:

Sharpe Ratio = (Return - Risk-Free Rate) / Standard Deviation of Returns

• Return: The average or expected return of your strategy.
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• Risk-Free Rate: The return on a "risk-free" asset (often based on U.S. Treasury bill rates).
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• Standard Deviation of Returns: Measures the volatility of your returns.

A higher Sharpe Ratio indicates better risk-adjusted performance, meaning you earn more return for the level of risk taken. It shows how much extra return you’re earning compared to a risk-free investment, adjusted for the asset’s volatility.
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Example Calculation of Sharpe Ratio

Let’s compare two trading strategies involving the Volatility 10 Index and Volatility 100 Index, assuming a risk-free rate of 2%:

• Strategy A (Volatility 10 Index):
  
  • Average Annual Return: 15%
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  • Annual Volatility: 10%
    
    Calculation:
    Sharpe Ratio=(15%−2%)10%=1.3
    
    
• Strategy B (Volatility 100 Index):
  
  • Average Annual Return: 25%
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  • Annual Volatility: 100%
    
    Calculation:
    Sharpe Ratio=(25%−2%)100%=0.23

The significant difference in the Sharpe Ratios arises from the varying levels of volatility: Strategy A (Volatility 10) has a Sharpe Ratio of 1.3, indicating better risk-adjusted returns, while Strategy B (Volatility 100) drops to 0.23, reflecting a poorer risk-return balance.
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Key Considerations When Using Volatility-Adjusted Returns

• Risk Management: Even if you choose to trade Strategy B, it’s essential to manage the higher risk effectively. Utilize stop-loss orders and precise position sizing to mitigate potential losses.
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• Trading Costs: Be aware of how spreads and overnight fees can impact your overall performance. These trading costs should be factored into your performance evaluations.
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• Leverage Considerations: Different Volatility Indices come with different leverage ratios. For instance, Volatility 10 may use higher leverage (1:5000) compared to Volatility 100 (1:1000). While lower leverage reduces exposure, the inherent volatility of the asset still presents substantial risks.
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Conclusion

In conclusion, assessing volatility-adjusted returns is crucial for understanding and optimizing your trading performance in the forex market, particularly when dealing with Volatility Indices. By factoring in volatility and using metrics like the Sharpe Ratio, traders can make more informed decisions, identifying which indices offer the best balance of risk and return.

By analyzing these metrics and adjusting your strategies accordingly, you can position yourself for success in the dynamic forex landscape. Thank you for joining this lesson, and happy trading!