Calculation and mechanics
In the classic Sharpe ratio of William F. Sharpe the risk-free rate is first subtracted from the return. This excess return is divided by the standard deviation of the returns. With daily returns the metric is usually annualized with the square root of about 252 trading days. This requires a return observation for every trading day, days without a change in value enter with 0%.
Put simply, a Sharpe ratio of 1 means the annualized excess return is about as large as the annualized volatility. Over short periods the value can fluctuate strongly because few observations have a strong influence on the mean and the standard deviation.
The standard deviation treats positive and negative swings alike. The Sharpe ratio can also underestimate risks that occur only rarely. For strategies with many small gains and single large losses, such as certain option strategies, it can come out comparatively high over long calm phases although a considerable risk of loss exists.
Sharpe ratio = (avg return - risk-free rate) / standard deviation of returns x sqrt(252)
Distinction
The Sortino ratio only takes negative deviations below a defined threshold into account in the denominator. The Calmar ratio instead relates the annual return to the Max drawdown.
A classic Sharpe ratio is based on periodic returns relative to a portfolio or capital base. Derived from the realized results of a trading journal instead, it measures a different quantity. Such values are mainly suited for comparisons within the same evaluation and are not directly comparable with the Sharpe ratio of a fund or a benchmark.
Sources
Related terms
- Sortino ratio (Downside risk-adjusted return)
- Calmar ratio (Drawdown ratio)
- Max drawdown (Maximum drawdown, MDD, time in drawdown)
- Historical Volatility (Realised Volatility, HV)
All market and analytical information is provided for educational and analytical purposes only and does not constitute investment advice or a trading recommendation.