The Sharpe ratio measures how much return you get for the risk you take. Higher is better, it means smoother gains for the same reward. It's the number every fund quotes, which makes it the common language of risk adjusted return.
What is a good Sharpe ratio?
Per year, above 1 is solid, above 2 is very good, and above 3 is rare. Below 1 means you're not being paid much for the risk you're taking, and negative means you'd have done better by sitting on cash. But context matters, a Sharpe of 2 on 30 trades is probably luck, not skill. And don't compare a per trade Sharpe with an annualised one. Only trust a Sharpe built on a decent sample, after costs.
How do you calculate it?
Take your average return, subtract the risk free rate (what cash pays), then divide by the standard deviation of your returns. That standard deviation is your volatility, the spread of your results around the average. So Sharpe rewards two things at once: a bigger edge, and a smoother ride. Cut your volatility without cutting returns and your Sharpe rises, even if you made the exact same money.
Here's a quick example. Say a strategy averages 15% a year, cash pays 3%, and your returns swing around with a standard deviation of 8%. Your Sharpe is (15 - 3) / 8, which comes to 1.5, so you earn 1.5 units of return for each unit of risk, a solid number. Keep that same 15% return but cut the swing to 5%, and your Sharpe jumps to 2.4, same money, smoother ride.
Sharpe vs Sortino vs Treynor
Sharpe isn't the only risk adjusted number, and it isn't always the best one. The main three, side by side:
| Metric | Divides your return by | Best for |
|---|---|---|
| Sharpe | total volatility (up and down) | comparing almost anything, the common standard |
| Sortino | downside volatility only | strategies with big upside, small downside (trend, momentum) |
| Treynor | market risk (beta) | portfolios judged against a benchmark |
Now pay attention to this when you're reading Sharpe: it treats a big winning month as "risk" the same as a losing one, which punishes strategies that pop higher. That's why Sortino often gives a trend system the realistic score. Use Sharpe to speak the industry's language, Sortino to judge an asymmetric edge.
When does Sharpe lie to you?
When your returns aren't evenly spread. Sharpe assumes your gains and losses are normal and balanced, so it makes a strategy look safer than it really is when that strategy grinds out small steady gains for months and then takes one huge loss. A high Sharpe on a short record is a trap, not a trophy.
Frequently asked questions
Related terms
- Sortino Ratio — How much return a strategy earns for the losses it actually makes you feel.
- Maximum Drawdown — The deepest hole a strategy has dug you into, peak to bottom.
- Volatility — How much and how fast a strategy's returns swing around.
- Position Sizing — How many units you trade, set so one loss costs what you decided in advance and not an unknown amount.