The one-sentence definition
The Sharpe ratio is a strategy's return above the risk-free rate, divided by how much its returns fluctuate (their volatility). Higher means more reward for each unit of risk taken.
How it's calculated
Sharpe ratio = (average return - risk-free rate) / standard deviation of returns.
The top measures the excess return over a safe baseline (like short-term government bonds). The bottom measures volatility - how much the returns bounce around. For comparability, it's usually annualised.
A worked example
Strategy A returns 20% a year with a volatility of 10%. Strategy B also returns 20%, but with a volatility of 40%. Assume a risk-free rate of 4%.
Strategy A's Sharpe = (20% - 4%) / 10% = 1.6. Strategy B's Sharpe = (20% - 4%) / 40% = 0.4.
A has four times B's Sharpe ratio in this example because it earned the same excess return with lower volatility. That comparison says nothing by itself about liquidity, leverage, or losses outside the measured period.
Why it matters for backtesting
A backtest's total return tells you nothing about how bumpy the road was. The Sharpe ratio captures that, so you can prefer a strategy that earns its money calmly over one that earns the same amount through gut-wrenching volatility.
It's also a rough guard against cherry-picked, fragile results. A strategy with a great return but a tiny Sharpe is often relying on a few explosive moments rather than a consistent edge.
Common mistakes
Where the Sharpe ratio can mislead:
- Treating volatility as the only risk. Sharpe punishes upside swings as much as downside ones; it doesn't single out the losses that actually hurt.
- Comparing Sharpe ratios computed over different periods or frequencies. Daily, monthly, and annual figures aren't directly comparable unless consistently annualised.
- Reading it in isolation. A high Sharpe over a short, calm stretch can vanish in a crisis. Pair it with maximum drawdown for the full picture.