risk
Sharpe Ratio
Measures risk-adjusted returns — how much return you earn per unit of risk taken. The gold standard for comparing trading strategies.
Formula
Sharpe = (R_p - R_f) / σ_p
Variables
- Sharpe
- Sharpe ratio (higher = better risk-adjusted)
- R_p
- Portfolio annualized return
- R_f
- Risk-free rate (e.g., Treasury yield)
- σ_p
- Standard deviation of portfolio returns (annualized)
Worked Example
Inputs
- R_p
- 25% annual return
- R_f
- 5% (Treasuries)
- σ_p
- 15% annual volatility
Calculation Steps
- 1
Excess return = 25% - 5% = 20% - 2
Sharpe = 20% / 15% = 1.33
Result: Sharpe = 1.33 — good risk-adjusted performance
Intuition
Sharpe < 0.5 = poor. 0.5-1.0 = decent. 1.0-2.0 = very good. > 2.0 = exceptional (or too good — check for survivorship bias). A strategy returning 50% with 50% vol (Sharpe=1) is equivalent to 20% with 15% vol. Consistency matters more than magnitude.