Trading term

What is Sharpe ratio?

The Sharpe ratio measures return per unit of volatility, calculated as excess return divided by the standard deviation of returns. It answers whether gains came from genuine skill or from simply taking bigger swings.

Developed by William Sharpe, the ratio takes a return series, subtracts the risk-free rate, and divides by the standard deviation of those returns. Higher is better: more reward for each unit of variability endured. Roughly, under 1 is unremarkable, 1–2 is good, and above 2 is excellent — though the figure is only comparable between strategies measured over the same period and frequency.

What it captures is the difference between two records that finish in the same place. A system that grinds out +12R with small, consistent results and one that reaches +12R through violent swings look identical on a summary line, but the first has a far higher Sharpe — and a maximum drawdown a fraction of the size. That is a real distinction, and the Sharpe ratio is the standard way of expressing it.

Its well-known flaw is that standard deviation treats upside and downside identically, so a strategy is penalised for large gains exactly as much as for large losses. The Sortino ratio, which counts only downside deviation, exists precisely to address this.

Same destination, different journey
SAME DESTINATION — 12R EACHsteadystd dev0.80RSharpe0.75worst drawdown1Rvolatilestd dev3.83RSharpe0.16worst drawdown5RIdentical return. Roughly 5× the risk-adjusted quality.Return alone can’t be compared between strategies — that is the whole reason this ratio exists.

Both curves finish at +12R. One has a 0.80R standard deviation and a 1R drawdown; the other 3.83R and 5R. Return alone can't tell them apart — this ratio can.

For example

Two strategies both finish at +12R over 20 trades. The steady one has a standard deviation of 0.80R and a Sharpe of 0.75, with a worst drawdown of 1R. The volatile one has a standard deviation of 3.83R, a Sharpe of 0.16, and a 5R drawdown. Same destination, very different journey.

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Why it matters to you

Return alone is not comparable across strategies, because it says nothing about what was risked to get it. The Sharpe ratio is the common language for that comparison — it's what allocators use to rank funds, and it's the reason a modest, steady return can be worth more than a larger and wilder one.

⚠ It punishes big winners as harshly as big losers

Standard deviation is symmetric, so a strategy with occasional enormous gains — trend following, long options — scores poorly despite that being exactly the return profile many traders want. It also assumes roughly normal returns and misses tail risk entirely, which is how strategies that quietly sell insurance post beautiful Sharpes until the day they don't.

Frequently asked questions

What is the Sharpe ratio?

It's a measure of risk-adjusted return: excess return over the risk-free rate, divided by the standard deviation of returns. It expresses how much reward a strategy produced per unit of volatility.

What is a good Sharpe ratio?

Broadly, below 1 is unremarkable, 1–2 is good and above 2 is excellent. The figure is only meaningful compared with strategies measured over the same period and at the same frequency, since it scales with how often returns are sampled.

What's the difference between the Sharpe and Sortino ratios?

Sharpe divides by total standard deviation, so it penalises upside and downside volatility equally. Sortino divides by downside deviation only, which suits strategies whose returns are deliberately skewed toward occasional large gains.

What are the limitations of the Sharpe ratio?

It treats large gains as risk, assumes roughly normal returns, and ignores tail risk — so strategies with rare catastrophic losses can show excellent Sharpe ratios right up until the loss occurs. Read it alongside maximum drawdown.

Related terms

BacktestingBacktesting runs a precisely defined set of trading rules over historical data to see how they would have performed on it. It is the cheapest way there is to reject a bad idea, and a poor way to prove a good one.Curve fittingCurve fitting, or over-optimisation, is tuning a strategy until it fits the historical data almost perfectly — including the random noise in it. The result looks superb in a backtest and fails immediately in live trading.Equity curveAn equity curve plots the running total of an account or a strategy over time, updated after every single trade it takes. Its shape — the slope, the smoothness, the depth of its dips — says more about a system than the final number does.ExpectancyExpectancy is the average amount you can expect to win or lose per trade, given your win rate and the relative size of your wins and losses. It is the single number that says whether a strategy makes money.
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