Sharpe ratio answers one question: how much return did this strategy produce per unit of volatility it put you through? Formula: (return − baseline) ÷ standard deviation of those returns. The baseline is usually the risk-free rate; in trading contexts, it is sometimes just zero.
The higher the number, the cleaner the ride for the same end result. Two strategies that returned 30 percent on the year can have very different Sharpes. The one with the smoother equityEquityThe live value of your broker account, including the floating profit or loss of open positions.Click the word to learn more curve has the higher number. Same arrival, calmer trip.
Rough guideposts cited in the industry: Sharpe near 1 is acceptable, above 2 is strong, above 3 is excellent and rare. Two caveats are worth remembering. Sharpe assumes normally distributed returns, an assumption frequently violated in practice. It also ignores sample length: a six-month Sharpe is not the same evidence as a five-year Sharpe.
The quiet flaw of Sharpe is that it punishes upside volatility just as much as downside. A great month is treated as volatility, even though nobody complains about great months. Sortino was designed to fix this by counting only the bad swings. Both numbers belong on the same page. Javlot reports them next to each other, alongside drawdownDrawdownThe drop in account equity from a peak to the trough that follows, expressed as a percent of the peak.Click the word to learn more and the underlying curve.