Sharpe Ratio
The Sharpe ratio is the excess return of a strategy (return minus the risk-free rate) divided by its volatility (standard deviation of returns). Higher is better — it tells you how much return you are getting per unit of risk taken.
Formula
Sharpe = (R_p − R_f) / σ_p, where R_p is portfolio return, R_f is the risk-free rate, and σ_p is the standard deviation of portfolio returns.
Interpretation
- < 1.0 — sub-par; you're taking on volatility without proportional return
- 1.0 – 2.0 — acceptable for retail strategies
- 2.0 – 3.0 — strong
- > 3.0 — exceptional, often unsustainable, often a sign of overfitting in backtests
Caveats
Sharpe penalises upside volatility just as much as downside. The Sortino ratio (which uses only downside deviation) is sometimes more honest. Sharpe also assumes returns are normally distributed — they aren't, especially in crypto.
Related Terms
Sortino Ratio
Like Sharpe, but only counts downside volatility — a more honest measure for asymmetric strategies.
Profit Factor
Profit factor is gross winning trades divided by gross losing trades — a quick test of whether a strategy has any edge at all.
Drawdown
Drawdown is the percentage decline from a peak in your account equity to the next trough — the most important number in risk management.
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