What is the Sharpe ratio?
The Sharpe ratio measures how much return a strategy earns for every unit of risk it takes. In plain terms: how much you made, compared with how rough the ride was to make it.
It exists because return on its own is a misleading number. Two strategies can both hand you 30% in a year, and one of them can be a disciplined system while the other is a gamble that happened to land. The account balance looks identical at the finish line. The Sharpe ratio is the number that tells them apart.
"The right question is never how much did you make. It is how much did you risk to make it." — Ahmed Tahsin, Founder & CEO
How is the Sharpe ratio calculated?
The formula divides your excess return by your volatility:
Three inputs, each meaning something practical:
- Strategy return — what the account actually made over the period.
- Risk-free rate — what you could have earned with no risk at all, typically short-term government paper. Beating this is the minimum bar; if a strategy cannot, it is not paying you for the risk.
- Standard deviation — how much the returns jumped around month to month. This is the "roughness of the ride", and it is what most investors ignore entirely.
The subtraction matters. If cash pays 4% and your strategy made 5%, the excess is 1%, not 5%. Strategies that looked impressive in a zero-rate world look very different once cash pays something.
What is a good Sharpe ratio?
| Sharpe ratio | What it means |
|---|---|
| Below 1 | The return does not justify the risk taken |
| 1 to 2 | Good — balanced return against controlled risk |
| Above 2 | Excellent |
| Negative | Losing against the risk-free alternative |
A worked example makes the point better than the table. Two strategies both return 30% for the year:
- Strategy A: Sharpe 1.8. Steady monthly gains, small dips, nothing that made you consider withdrawing.
- Strategy B: Sharpe 0.6. Violent swings, a month down 22%, a month up 30%.
Same destination. One drove with discipline, the other gambled and happened to win this time. If next year's conditions differ, only one of those is likely to repeat. And in practice most investors never even reach the finish line with Strategy B, because they withdraw during the 22% month.
Why does the Sharpe ratio matter more than the return?
Because the return tells you what happened, and the Sharpe ratio hints at whether it can happen again.
A high return with a low Sharpe usually means large positions and loose risk control. That combination works until the one month it does not, and then it removes several years of gains at once. A high Sharpe means the result came from a repeatable process rather than a lucky run of oversized bets.
It also predicts your own behaviour, which is the part investors underestimate. High-volatility strategies are abandoned at the bottom by the people who funded them. A strategy you can actually sit through is worth more than a theoretically superior one you will bail out of.
Use it as a comparison tool: line up two strategies, look at the Sharpe before you look at the headline return, and you will rank them very differently.
What are the limits of the Sharpe ratio?
It is a useful number, not a verdict, and it has real weaknesses.
Standard deviation treats a surprise +15% month as "risk" exactly like a −15% month. A strategy with occasional large gains can score worse than a flat one, which is not how any investor actually experiences it.
Measuring over a calm stretch flatters the number. Always ask what period it covers, and make sure it includes a bad one.
A strategy can post a respectable Sharpe and still have had a drawdown deep enough to end your participation. That is why you should read it alongside maximum drawdown, which answers a different and equally important question: how bad did it actually get?
Three months of data produces a Sharpe number, and that number is close to meaningless. Look for a track record long enough to include different market conditions.
How do you check it on a real strategy?
Do not accept a Sharpe ratio quoted in marketing material. Ask for the verified track record it was calculated from, then confirm the period is long enough to contain a losing stretch, and read the drawdown alongside it.
The Sharpe ratio is among the first things TIC examines before releasing any strategy, and our performance and volatility data are published on Myfxbook so you can calculate it yourself rather than take our word for it. How to read a Myfxbook track record walks through exactly what to look at, and what is drawdown covers the number that belongs next to it.
trading carries high risk and you may lose your capital. Past performance does not guarantee future results. Educational content only, not investment advice.
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