What is the Sharpe ratio?
The Sharpe ratio measures how much return a strategy earns per unit of risk taken, calculated as excess return divided by the standard deviation of returns. A higher Sharpe means a smoother ride for the same reward, which is why it is the most quoted single number for comparing strategies.
Two strategies can both return 30% a year while being completely different investments: one grinding steadily upward, the other lurching through stomach-turning swings. Raw return cannot tell them apart. The Sharpe ratio exists to make that difference visible.
How is the Sharpe ratio calculated?
Take the strategy's return above a risk-free baseline, then divide by the standard deviation of its returns over the same period. The result is usually annualized so strategies of different lengths compare on one scale. In plain terms: reward earned, divided by how bumpy the road was.
The denominator is the point. Volatility stands in for risk, so a strategy is rewarded for consistency as much as for profit. Doubling returns while tripling volatility makes the Sharpe ratio worse, not better.
What is a good Sharpe ratio?
For most retail strategies, above 1 is respectable, above 2 is strong, and above 3 in a backtest should trigger suspicion rather than celebration, because real sustained Sharpe ratios that high are rare. Buy-and-hold on major markets has historically lived around 0.4 to 0.6, which makes a useful mental baseline.
Context matters: trade frequency, leverage, and the test period all move the number. Comparing Sharpe ratios is most meaningful between strategies tested on the same market and period.
Where does the Sharpe ratio mislead?
It punishes all volatility equally, including upside. A strategy with occasional explosive wins looks riskier by Sharpe than its downside justifies, which is what the Sortino ratio corrects by counting only downside swings. It also assumes bumpiness is well described by standard deviation, so strategies with rare, severe losses, selling options is the classic case, can carry flattering Sharpe ratios right up until the day they do not.
And like every backtest statistic, it degrades from backtest to live trading as real costs and market change arrive. Treat a backtest Sharpe as an optimistic ceiling, not a forecast.
The Sharpe ratio on Horizon
Horizon backtest reports state the Sharpe ratio alongside maximum drawdown and the equity curve. Read them as a set: the Sharpe summarizes the whole ride's smoothness, while the drawdown names the single worst stretch, and either one alone can hide what the other reveals.
Frequently asked questions
- What is a good Sharpe ratio for a trading strategy?
- Above 1 is respectable and above 2 is strong for most retail strategies after costs. Sustained live Sharpe ratios above 3 are rare, so a backtest showing one deserves scrutiny for overfitting before it deserves capital.
- Can the Sharpe ratio be negative?
- Yes. A negative Sharpe means the strategy returned less than the risk-free baseline over the period. Rankings between negative Sharpe ratios are not meaningful; negative simply reads as failed for that period.
- What is the difference between the Sharpe and Sortino ratios?
- Sortino divides by downside deviation only, while Sharpe divides by total volatility. A strategy with big upside swings and small downside ones scores much better on Sortino. Comparing the two ratios for one strategy shows how much of its volatility is the good kind.
- Why is my live Sharpe ratio lower than my backtest?
- Real slippage and fees shave the numerator, live markets differ from the tested period, and some backtest edge is usually overfitting that does not travel. A modest decline is expected; a collapse suggests the backtest edge was mostly memorized noise.
