Hi Chorlton,
This is a way of normalizing for leverage.
You'll have a bigger sample than this, but this is OK for illustration.
Trader 1 has no leverage and gets the following monthly returns:
Month1: +10%, Month2: +6%, Month3: +3%, Month4: -1% giving an average return of 4.5% per month
Trader 2 uses 10:1 leverage and hence has an average return of 45% per month.
The question is who has the better performance; on the surface trader2 seems to be 10x better.
Use the following formula to get an annualised, volatility-adjusted performance metric:
(average monthly return) x 12
------------------------------------
stdv x sqrt(12)
Trader 1's performance metric is 54/16 = 3.3
Trader 2's performance metric is 540/160 = 3.3
i.e they have performed equally.
Hope this helps,
Joey