Sharpe Ratio
The Sharpe ratio measures return per unit of risk: excess return over a risk-free rate divided by the volatility of returns.
Two strategies both made 15% last year. One got there smoothly; the other swung 30% up and down along the way. The Sharpe ratio puts that difference into a number: how much return above the risk-free rate a strategy earned for each unit of volatility it took. It is the most widely quoted risk-adjusted performance measure — and, like any single number, it hides as much as it shows. This entry explains the calculation, typical values and the main caveats.
- Reading time
- 4 min
- Also called
- Sharpe, Risk-adjusted return, Reward-to-volatility ratio
- Updated
The Sharpe ratio in plain words
Take the return, subtract what you could have earned risk-free (for example on Treasury bills), and divide by how much the returns bounced around (their standard deviation).1
A higher Sharpe ratio means more return for each unit of volatility. A strategy returning 12% with 8% volatility, with a 4% risk-free rate, has a Sharpe ratio of (12 − 4) ÷ 8 = 1.0. See Volatility.
How to calculate the Sharpe ratio, step by step
Collect periodic returns
Daily, weekly or monthly returns of the strategy or portfolio.
Subtract the risk-free rate
For each period, or on average, using the matching short-term government rate. See Treasury Bills, Notes and Bonds.
Average the excess returns
Mean excess return per period.
Measure volatility
Standard deviation of the periodic returns.
Divide
Sharpe = mean excess return ÷ standard deviation.
Annualise
Multiply by √(periods per year): √12 for monthly, about √252 for daily.
Worked examples
Example 1 — Annual figures
ComparisonStrategy A returns 15% with 10% volatility; strategy B returns 15% with 25% volatility. The risk-free rate is 4%.
| Sharpe A | (15 − 4) ÷ 10 = 1.10 |
| Sharpe B | (15 − 4) ÷ 25 = 0.44 |
Same return, very different ride. A delivered two and a half times as much excess return per unit of volatility.
Example 2 — Annualising monthly data
AnnualisingMonthly excess returns average 0.8% with a monthly standard deviation of 3%.
| Monthly Sharpe | 0.8 ÷ 3 ≈ 0.27 |
| Annualised | 0.27 × √12 ≈ 0.92 |
Annualising makes Sharpe ratios comparable across strategies measured at different frequencies.
Example 3 — A Sharpe ratio that hides risk
Tail riskA strategy sells far out-of-the-money options and makes small, steady gains for two years — Sharpe ratio 2.5 — then loses 40% in one month during a crash.
| Before the crash | High Sharpe, low measured volatility |
| The crash | −40% |
Volatility-based measures can understate rare, large losses. Always look at drawdowns and the worst periods too. See Drawdown.
Sharpe ratio vs. related measures
| Aspect | Risk measure used | Better for |
|---|---|---|
| Sharpe ratio | Total volatility | General comparisons |
| Sortino ratio | Downside volatility only | Strategies with skewed returns |
| Calmar ratio | Maximum drawdown | Judging pain of declines |
| Information ratio | Tracking error vs. a benchmark | Comparing managers |
Where the Sharpe ratio is used
Comparing strategies
Ranking strategies or funds by risk-adjusted return.
Portfolio construction
Choosing allocations that improve return per unit of risk. See Risk Parity, Minimum Variance and the Efficient Frontier.
Backtest reports
A standard summary statistic. See Backtesting.
Sizing
Strategies with higher Sharpe ratios can support more capital for the same volatility. See Volatility Targeting.
Advantages and disadvantages
Advantages
- Widely understood and reported.
- Combines return and volatility in one number.
- Allows comparison across strategies and assets.
Disadvantages
- Treats upside and downside volatility the same.
- Understates rare, large losses (tail risk).
- Sensitive to the period chosen and return frequency.
- Can be inflated by smoothed or illiquid prices.
Going deeper
Read as far as you need. Each level builds on the one before it.
What is a good Sharpe ratio?
Beginner
As a rough guide, many practitioners consider an annual Sharpe ratio around 1 good and above 2 excellent for a real track record. Backtests showing 3 or more deserve suspicion. See Overfitting.
Sortino and downside risk
Intermediate
The Sortino ratio replaces total volatility with downside volatility, so strategies with large upside swings are not penalised for them.2 See Sortino Ratio.
Assumptions behind the ratio
Advanced
The Sharpe ratio, introduced by William F. Sharpe, implicitly treats standard deviation as the full measure of risk. Returns with fat tails or negative skew, typical of option-selling and leveraged strategies, carry more risk than their Sharpe ratio suggests.
Common mistakes
Comparing different frequencies
Annualise before comparing daily and monthly figures.
Ignoring drawdowns
A high Sharpe ratio can coexist with a severe crash.
Short samples
A year of data says little about a strategy’s true Sharpe ratio.
Forgetting the risk-free rate
Excess return, not total return, goes in the numerator.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- Sharpe = (return − risk-free rate) ÷ volatility.
- Higher means more excess return per unit of volatility.
- Annualise with √(periods per year) before comparing.
- It treats upside and downside volatility alike.
- Check drawdowns and tail risk alongside it.
Frequently asked questions
Can the Sharpe ratio be negative?
Is a higher Sharpe ratio always better?
What is the difference between Sharpe and Sortino?
Further learning
- Volatility
The denominator of the ratio.
- Drawdown
The risk the Sharpe ratio can hide.
- Backtesting
Where Sharpe ratios are usually first seen.
- Expectancy
A trade-level view of edge.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- William F. Sharpe, Stanford University. The Sharpe Ratio (Journal of Portfolio Management, 1994) (opens in a new tab) Checked .
- Charles Schwab. Using the Sortino Ratio to Gauge Downside Risk (opens in a new tab) Checked .
Read more elsewhere
- Trading Metrics (our sister site): Sharpe Ratio (opens in a new tab)
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. Trading Metrics is our sister site, under the same ownership; we are not affiliated with any other publisher linked above. Last reviewed . Report an error or request a source credit.