Sharpe Ratio
Sharpe = (Return − RiskFreeRate) / StdDev(Returns). It answers: how much extra return are you getting per unit of return volatility? Two traders earning 30% per year are not equally good if one had a maximum drawdown of 5% and the other 40% — Sharpe captures that difference.
Sharpe penalizes upside volatility just as much as downside volatility, which is a known weakness. A trader with explosive winning months and modest losing months will have a similar Sharpe to a trader with consistent small wins. The Sortino ratio addresses this by only counting downside deviation.
Sharpe is most useful for comparing strategies on similar timeframes and asset classes. Comparing a high-frequency Sharpe of 4 to a swing trader's Sharpe of 1.5 is meaningless because the holding periods differ. Annualize and segment first.
Related reading
- Why Every Trader Needs a Trading Journal (And How to Keep One) — Blog
- Kelly Criterion for Crypto Trading: A Practical Approach — Blog
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