Sharpe Ratio
In one line: It tells you if the reward was worth the bumpy ride.
Explain it like I'm 5
Imagine two kids selling lemonade.
- Mia makes about $10 every day. Rain or shine, it's always close to $10.
- Leo also makes $10 a day on average, but some days he makes $40 due to higher foot trafic, and other days he loses $20 because every now and then bullies pass by that route and steal his money. It's a wild rollercoaster.
They both end up with the same money. But Mia's stand feels safe, and Leo's feels scary. The Sharpe ratio is a number that rewards Mia for being steady and marks Leo down for having a scarier journey.
What it actually measures
The Sharpe ratio answers one question: were the returns big enough to justify how bumpy they were?
It takes your return, subtracts what you could have earned risk-free (like a savings account or short-term government bond), and then divides that by how much your returns bounced around (their standard deviation, a.k.a. volatility).
The formula
Sharpe ratio = (Portfolio return − Risk-free rate) / Standard deviation of returns
- Portfolio return — what you actually made over the period.
- Risk-free rate — the boring, near-guaranteed return you could have had instead.
- Standard deviation — a measure of how spread out your returns were. Small = calm, large = rollercoaster.
A quick example
Your account returns 12% over a year. A risk-free bond would have paid 2%. Your monthly returns wobbled with a standard deviation of 8%.
Sharpe = (12% − 2%) / 8% = 1.25
What is a "good" Sharpe ratio?
Rough rules of thumb for an annual Sharpe ratio:
| Sharpe ratio | Read as |
|---|---|
| Below 1 | Returns are not paying you well for the risk |
| 1 – 2 | Solid |
| 2 – 3 | Very good |
| Above 3 | Excellent (and rare — double-check your data) |
Why traders care
Two strategies can show the same profit, but the one with the higher Sharpe ratio got there with less stress and smaller drawdowns. That makes it easier to stick with, easier to size up, and less likely to blow up during a bad streak.
Watch-outs
- It punishes big up moves the same as big down moves. The Sortino ratio fixes this by only counting downside wobble.
- It needs enough data to be meaningful — a handful of trades won't give a reliable number.
- It assumes returns are roughly bell-shaped; strategies with rare huge losses can look safer than they are.
See your own Sharpe ratio
TradeNoter calculates the Sharpe ratio on your real trade history automatically, alongside your win rate, expectancy, and drawdown — so you can tell whether your edge is genuinely smooth or just lucky so far.