Sharpe Ratio

What is the Sharpe ratio in trading?

A historic Sharpe ratio compares average return above a defined baseline with how much those returns varied during the same period.

In simple words, it asks: how much return above the chosen baseline was recorded for each unit of variation in the return series?

The simplified historic formula

(average return − chosen baseline return) ÷ standard deviation of those returns

Standard deviation is a measure of how widely the returns moved around their average. A larger value means the selected returns varied more.

A fictional monthly example

Imagine a defined series has a 2% average monthly return, a chosen monthly baseline of 0.5%, and monthly return variation of 3%:

(2% − 0.5%) ÷ 3% = 0.50

The 0.50 describes only this fictional return series, baseline, monthly frequency and calculation method. It is not a universal good or bad threshold.

What must stay consistent?

1. Return series: define what value each return uses.
2. Frequency: compare daily with daily or monthly with monthly.
3. Baseline: use the same chosen comparison return.
4. Period: show the start and end dates.
5. Method: state how costs and annualisation are handled.

Two Sharpe ratios are not directly comparable when these inputs differ.

It is not a prop-firm consistency rule

A prop-firm consistency rule may compare a best day or best trade with total profit. That is a different formula with program-specific consequences. A Sharpe ratio does not decide whether your account passed a firm rule.

What does the ratio leave out?

• It does not show the shape of the equity curve.
• It does not show when drawdown happened.
• It does not show tail risk, trade count or rule adherence by itself.
• A higher historic value does not predict future performance.

Where should a beginner start?

Start with win rate, average win and average loss, expectancy, profit factor and drawdown. The trading performance metrics guide puts them in a practical reading order before Sharpe ratio is added as an advanced view.