Risk & Money ManagementReward-to-Variability Ratio
Sharpe Ratio
A risk-adjusted return measure: return in excess of the risk-free rate divided by the standard deviation of returns.
What Sharpe Ratio means
The Sharpe ratio is calculated as the average return of a strategy minus the risk-free rate, divided by the standard deviation of those returns. Both figures must cover the same interval, and a ratio computed on daily or monthly data is annualised by multiplying by the square root of the number of periods in a year, such as the square root of 252 for daily trading days. The result answers a simple question: how much excess return is earned for each unit of volatility endured.
As a rough convention, values below 1 are considered unremarkable, values around 1 to 2 respectable and values above 2 strong, though comparisons are only fair between strategies measured over similar periods. The main weakness is that standard deviation penalises upside and downside movement equally, so a strategy with occasional large gains is scored as harshly as one with occasional large losses. Ratios also flatter approaches with rare catastrophic tails, which can look extremely smooth right up until they are not.
Worked example
A strategy returning 12 percent a year with a 3 percent risk-free rate and a 15 percent standard deviation of annual returns has a Sharpe ratio of (12 - 3) divided by 15, or 0.6.
Related terms
- Sortino RatioA variant of the Sharpe ratio that divides excess return by downside deviation only, ignoring upside volatility.
- Calmar RatioAnnualised return divided by maximum drawdown over the same window, conventionally measured across three years.
- VolatilityThe magnitude of price fluctuation over a period, usually measured as the standard deviation of returns or as an average range.
- DrawdownThe decline from a peak in account equity to a subsequent trough, usually stated as a percentage of the peak.
- Profit FactorGross profit divided by gross loss across a set of trades; any value above 1.0 indicates a net profitable system.
Frequently asked questions
What does Sharpe Ratio mean in forex trading?
A risk-adjusted return measure: return in excess of the risk-free rate divided by the standard deviation of returns.
How does Sharpe Ratio work in practice?
As a rough convention, values below 1 are considered unremarkable, values around 1 to 2 respectable and values above 2 strong, though comparisons are only fair between strategies measured over similar periods. The main weakness is that standard deviation penalises upside and downside movement equally, so a strategy with occasional large gains is scored as harshly as one with occasional large losses. Ratios also flatter approaches with rare catastrophic tails, which can look extremely smooth right up until they are not.
What is an example of Sharpe Ratio?
A strategy returning 12 percent a year with a 3 percent risk-free rate and a 15 percent standard deviation of annual returns has a Sharpe ratio of (12 - 3) divided by 15, or 0.6.
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