Sharpe ratio
The Sharpe ratio measures return earned per unit of risk taken, using the standard deviation of returns as the risk measure. It compares strategies that return alike but shake very differently. Run this calculation now: how to measure your own performance
Formula and reading
Sharpe = (average portfolio return − risk-free rate) ÷ standard deviation of returns. Applied to daily returns it is usually annualised by multiplying by the square root of 252, the approximate number of trading sessions in a year. Common readings: below 1 is weak, 1 to 2 is acceptable, above 2 is good, and above 3 deserves suspicion before celebration.
Two accounts that finished the year at 30% may have Sharpe ratios of 0.8 and 2.4. The second got there with far less swing — and is the only one of the two a trader can repeat without abandoning the process halfway.
Limitations that matter
Sharpe punishes upside and downside volatility alike, which penalises strategies with rare, enormous wins. It also assumes well-behaved return distributions, which leveraged short-volatility trading does not have: the ratio looks beautiful until the day it does not.
In practice, compute it over at least a few months of data, always compare it with Sortino — which only punishes downside — and never switch strategy over a difference of tenths.