Sharpe ratio explained: return for the risk you take
What the Sharpe ratio measures, how to calculate it, what a good number looks like, and why two strategies with the same profit can be completely different.
Profit alone does not tell you whether a strategy is good. A system that makes 30% a year while swinging 40% up and down is a very different thing from one that makes 30% with gentle, steady steps. The Sharpe ratio is the classic way to put that difference into one number.
The formula in plain words
Sharpe ratio = average return ÷ standard deviation of returns. Take the returns for each day (or week, or month), work out their average and how much they wobble around that average, and divide one by the other. Strictly, you first subtract the risk-free rate, what cash in a bank would have earned, but for short-term trading that part is small.
To compare strategies, the ratio is usually annualised. With daily returns you multiply by the square root of the number of trading days in a year, roughly 16 for 252 days.
A worked example
- Average daily return: 0.10%
- Standard deviation of daily returns: 1.0%
- Daily Sharpe: 0.10 ÷ 1.0 = 0.10
- Annualised Sharpe: 0.10 × 16 ≈ 1.6
What is a good Sharpe ratio?
- Below 0.5: the return barely pays for the swings.
- Around 1: solid. Many professional funds live between 0.5 and 1.5 over long periods.
- Above 2: excellent, and worth double checking. Very high Sharpe ratios in a backtest are often a sign of missing costs, too few trades or rules fitted to the past.
Where Sharpe falls short
Sharpe treats a sudden jump up the same way as a sudden fall, and it assumes returns behave like a neat bell curve. Trading returns rarely do. Strategies that collect many small wins and occasionally take a large loss can show a flattering Sharpe ratio right up until the large loss arrives. That is why we always read it together with other measures.
Average return ÷ volatility of returnsReward per unit of overall swinginess. Above 1 is good, above 2 is rare over long periods.
Average return ÷ volatility of losing periods onlyLike Sharpe, but only punishes downside swings.
Yearly return ÷ maximum drawdownHow much you earn for the worst fall you had to survive.
Gross profit ÷ gross lossAbove 1 makes money. 1.3 to 2 is typical of real, robust systems.
(Win rate × average win) - (loss rate × average loss)What one trade is worth on average, after costs.
Largest fall from a peak, as % of starting balanceThe pain number. Always check it includes open trades.
Sortino and Calmar, the useful cousins
The Sortino ratio uses only the downside swings in the bottom of the fraction, so a strategy is not punished for big winning days. The Calmar ratio divides the yearly return by the maximum drawdown, which answers a very practical question: how much did I earn for the worst fall I had to live through?
Tip: when you compare two strategies, compare them at the same drawdown. A strategy that earns more simply by trading bigger lots has not got better, it has only got riskier.
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Risk warning. Trading leveraged products such as CFDs carries a high risk of losing money. Backtest figures are simulations, not real results, and past performance does not guarantee future results. Read the risk disclosure before you connect an account. Nothing here is financial advice.