Sharpe ratio explained: risk-adjusted return measurement

By Ken Chigbo, Founder, KenMacro. Published 2026-05-12.

What is Sharpe ratio?

Sharpe ratio is a risk-adjusted return metric that measures excess return per unit of total volatility. The formula is (R minus Rf) divided by sigma, where R is the strategy's average annualised return, Rf is the risk-free rate (typically the 3-month Treasury bill yield), and sigma is the annualised standard deviation of returns. A strategy returning 15 per cent per year with 10 per cent volatility, at a 4 per cent risk-free rate, has a Sharpe of (15 minus 4) divided by 10, equal to 1.1. Sharpe penalises both upside and downside volatility (Sortino ratio is a variant that penalises only downside volatility). Sharpe is the most widely cited risk-adjusted-return metric in retail and institutional asset management.

How traders use Sharpe ratio

Traders use Sharpe ratio to benchmark trading strategies against each other and against passive benchmarks. The S&P 500 buy-and-hold has run a long-term Sharpe of roughly 0.4 to 0.5. A retail trading strategy needs to beat that hurdle to justify the effort. A Sharpe of 1.0 or above signals a structurally sound strategy; below 0.5 signals the strategy may not be worth the time spent. Sharpe must be measured over at least 100 trades and one full market cycle to be statistically meaningful; a six-trade backtest Sharpe is noise. The desk publishes Sharpe ratios for its deployed frameworks (OMEGA-25, SIGMA-X, EPSILON) measured over multi-year backtest windows with realistic costs applied. Sharpe is also the primary metric prop firms use to evaluate funded-trader performance.

Common misconceptions about Sharpe

The first misconception is that higher Sharpe is always better. Very high Sharpe ratios (4.0 plus) are often the product of small sample sizes, hidden tail risk (a strategy that rarely loses but loses catastrophically when it does), or curve-fitting. The second is that Sharpe is comparable across strategies. Sharpe assumes returns are normally distributed; strategies with fat-tailed distributions (option-selling, mean-reversion) can post high Sharpe ratios that hide blow-up risk. The third is that Sharpe captures all relevant risk. Sortino ratio (downside-only) and Calmar ratio (return over max drawdown) capture different facets and are often more informative for retail trading.

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Frequently asked

What is a good Sharpe ratio for a trading strategy?

A Sharpe ratio above 1.0 is considered good for a trading strategy, above 2.0 is excellent, above 3.0 is rare and typically institutional with significant infrastructure. The S&P 500 buy-and-hold long-term Sharpe is roughly 0.4 to 0.5. A retail strategy must beat that hurdle to justify the time spent. Sharpe must be measured over at least 100 trades and one full market cycle.

How do I calculate Sharpe ratio?

Sharpe ratio equals (R minus Rf) divided by sigma, where R is the strategy's average annualised return, Rf is the risk-free rate (typically the 3-month Treasury bill yield), and sigma is the annualised standard deviation of returns. For a strategy returning 15 per cent with 10 per cent volatility at a 4 per cent risk-free rate, Sharpe equals 1.1. Most backtesting platforms calculate Sharpe automatically.

Sharpe ratio vs Sortino ratio: which is better?

Sharpe penalises both upside and downside volatility. Sortino penalises only downside volatility, which more closely matches what traders actually care about. For strategies with asymmetric return distributions (most directional trading), Sortino is more informative than Sharpe. Both should be cited together when documenting strategy performance.

Educational analysis only. Past performance does not guarantee future results. Manage risk against your own portfolio.