Definition
Sharpe ratio
The Sharpe ratio measures excess return per unit of volatility. Definition, formula, how to read the value, and the three ways the number is inflated.
The Sharpe ratio is excess return divided by volatility: subtract the risk-free rate from a strategy’s return and divide by the standard deviation of those returns. It answers how much compensation the strategy delivered per unit of risk taken. Above 1.0 is generally considered good and above 2.0 excellent, but the figure is only comparable between strategies measured over the same period at the same frequency.
- Also known as
- risk-adjusted return · reward-to-variability ratio
How it is calculated
Sharpe = (Return − Risk-free rate) ÷ Standard deviation of returns
Annualise by scaling: Sharpe_annual = Sharpe_period × √(periods per year)
Sortino replaces the denominator with downside deviation only.
Worked example: 18% return, 4% risk-free rate, 12% volatility → (18 − 4) ÷ 12 = 1.17.
It penalises upside as well as downside
Standard deviation treats a large gain and a large loss identically, so a strategy with occasional big winners is scored the same as one with occasional big losers. The Sortino ratio exists for this reason: it uses downside deviation only. For strategies with deliberately skewed payoffs — trend following, long options — Sharpe systematically understates quality.
Sampling frequency changes the answer
A Sharpe computed on daily returns and annualised by √252 is not the same statistic as one computed on monthly returns annualised by √12, and serial correlation in returns makes the higher-frequency version optimistic. When comparing published figures, the frequency and the annualisation convention matter as much as the value.
How it gets misread
A high Sharpe is routinely read as a low-risk strategy. It is a smoothness measure, not a survival measure: a strategy selling tail risk shows an excellent Sharpe right up to the event that ends it. Read Sharpe next to maximum drawdown, never instead of it.
Sources
- The Sharpe Ratio — The Journal of Portfolio Management (author's reprint, Stanford University)
- The Deflated Sharpe Ratio — The Journal of Portfolio Management (author copy, David H. Bailey)
Definitions are educational. Nothing here is investment advice, and no metric described on this page predicts future results.
Definitions are the easy part
Knowing what drawdown means is not the same as having a system that halts on it. QANTERION applies these limits while a strategy runs.