1. What is the Sharpe Ratio
The Sharpe ratio measures return per unit of risk (volatility). Simply: two strategies with the same return — the one with less volatility (a smoother equity curve) has a higher Sharpe, i.e. "higher-quality" returns.
2. Why it matters
- High returns with wild volatility are hard to follow and easy to blow up on. Sharpe rewards stability, not just the size of returns.
- It's the standard measure to compare risk-adjusted performance across strategies/funds.
3. Reading it (qualitatively)
- Higher Sharpe means better return per unit of risk.
- At the same return, a smoother equity curve (less variation) has a higher Sharpe.
- Variants like Sortino penalize only downside volatility, which suits traders since upside volatility isn't "bad risk".
4. How to apply
- Use it to compare strategies with similar returns: pick the higher-Sharpe (smoother) one.
- Don't use it alone: Sharpe doesn't replace reading max drawdown and expectancy.
5. Worked example
Strategies A and B both return 30%/yr. A moves fairly evenly; B profits from a few big spikes between deep dips. A has the higher Sharpe → easier to follow, easier to keep capital, less likely to quit midway.
6. Common mistakes
- Looking only at returns, ignoring the volatility behind them.
- Using Sharpe alone while forgetting drawdown.
- Comparing Sharpe across different timeframes/frequencies without normalizing.
7. FAQ
- What Sharpe is good? Higher is better; the specific number depends on context — what matters is a fair comparison among like options.
- How is Sortino different from Sharpe? Sortino counts only downside volatility (the part you actually fear), which many traders find more sensible.
8. Tools
- A tool to compute Sharpe/Sortino from an equity curve or trade history.
9. Checklist
- ☐ Do I read returns alongside volatility (Sharpe)?
- ☐ Do I place Sharpe beside max drawdown?
- ☐ Is the comparison fair (same timeframe, same frequency)?