What is the Sharpe Ratio?

Understanding the Sharpe Ratio

The Sharpe ratio measures risk-adjusted performance by dividing a strategy’s excess return (over the risk-free rate) by its volatility. It tells you how much reward you earn per unit of risk, allowing comparison between strategies with different return profiles.

Calculating Sharpe

• Excess return: Annualized portfolio return minus the risk-free rate.
• Volatility: Standard deviation of returns over the same period.
• Sharpe ratio: Excess return ÷ volatility.

Practical Use

Use rolling Sharpe windows (monthly, quarterly) to monitor regime changes. A rising Sharpe suggests the strategy is delivering better risk-adjusted returns, while a falling Sharpe may signal edge decay or a volatility regime shift.

Limitations

Sharpe assumes returns are normally distributed and penalizes upside volatility the same as downside. High Sharpe ratios derived from short samples often indicate overfitting. Always stress test strategies against fat-tail events and inspect the distribution of returns rather than relying on a single number.

Advanced Guidance

Build a repeatable, rules‑based process so decisions are consistent across sessions and instruments. Start from context (higher‑timeframe structure, positioning, macro tone), then define precise triggers and invalidation on execution charts. Track spread and depth so your order type matches conditions. Pre‑compute scenarios (breakout, fakeout, mean‑revert) and map actions for each to reduce hesitation.

Execution Framework

• Plan entries at levels with confluence (structure, momentum, time‑of‑day).
• Place stops beyond the logical invalidation, not arbitrary distances.
• Target at least 2–3R; scale out methodically and trail remainder.
• Avoid thin liquidity windows unless the setup explicitly requires it.
• Record slippage and spreads; poor fills can erase edge.

Review Loop

• Journal setups by session and pair to learn where they excel.
• Tag trades by catalyst (news, trend continuation, range breakout).
• Recalculate expectancy monthly; prune underperforming variants.

Risk Controls

Keep daily loss limits, reduce size after consecutive losses, and pause during regime shifts. Survival enables compounding; treat discipline and execution quality as part of your edge.