Understanding Volatility-Adjusted Returns

This lesson looks at volatility-adjusted returns and how the concept applies specifically to trading Deriv's Volatility Indices. Getting a handle on this metric gives you a fuller picture of your trading performance — one that goes beyond raw profit and factors in the risk you actually took to get there.

Why Volatility-Adjusted Returns Matter

When you're trading, profit alone only tells half the story — the risk you took on to earn it matters just as much. Volatility-adjusted returns bring that risk into the picture, giving you a clearer read on how a strategy actually performed once you account for how much it swung along the way. That makes it a genuinely useful way to compare strategies across different market conditions.

Key Concepts to Know

Raw returns: Simply your profit or loss, usually expressed as a percentage. Grow $1,000 into $1,100, and your raw return is 10%.

Volatility: A measure of how much an asset's price moves over time. Higher volatility means bigger price swings — and correspondingly higher risk.

Volatility-adjusted returns: This metric adjusts your raw return based on the risk you took on to earn it. One common way to calculate it is the Sharpe Ratio:

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

• Return: The average or expected return of your strategy
• Risk-free rate: The return on a "risk-free" benchmark asset (often based on U.S. Treasury bill rates)
• Standard deviation of returns: A measure of how much your returns themselves have varied

A higher Sharpe Ratio means better risk-adjusted performance — you're earning more return for the risk you're taking on, relative to a risk-free benchmark.

Worked Example: Comparing Two Strategies

Let's compare two hypothetical strategies — one on the Volatility 10 Index, one on the Volatility 100 Index — assuming a risk-free rate of 2%:

Strategy A (Volatility 10 Index):

• Average annual return: 15%
• Annual volatility: 10%
• Sharpe Ratio = (15% − 2%) ÷ 10% = 1.3

Strategy B (Volatility 100 Index):

• Average annual return: 25%
• Annual volatility: 100%
• Sharpe Ratio = (25% − 2%) ÷ 100% = 0.23

The gap between these two numbers comes down entirely to volatility. Strategy A's Sharpe Ratio of 1.3 reflects a stronger risk-adjusted return, while Strategy B's 0.23 shows a much weaker balance between risk and reward — even though the raw return on Strategy B looks higher on paper.

Things Worth Keeping in Mind

Risk management: Even if you choose to run a strategy like Strategy B, managing that higher risk properly still matters. Stop-loss orders and careful position sizing go a long way toward keeping potential losses in check.

Trading costs: Spreads and other trading costs eat into your actual performance, so factor them in whenever you're evaluating how a strategy has really done.

Leverage: Leverage varies across Volatility Indices — on the UAE offering, for example, Volatility 10 carries a maximum leverage of up to 1:1000, while Volatility 100 sits at up to 1:500. Lower leverage on the more volatile index reduces your exposure somewhat, but the underlying volatility of the instrument still carries real risk regardless.

Conclusion

Looking at volatility-adjusted returns is a genuinely valuable habit for understanding and refining how you trade Volatility Indices. By factoring in volatility and leaning on metrics like the Sharpe Ratio, you can make better-informed decisions about which indices actually offer the strongest balance of risk and reward for your own strategy.

Keep an eye on these metrics as you refine your approach, and you'll be in a stronger position as you continue trading Volatility Indices. Thanks for joining this lesson, and happy trading!