Sharpe ratio
The Sharpe ratio measures a strategy's risk-adjusted return, by dividing its excess performance by the volatility of its returns.
Developed by William Sharpe, this ratio answers the question: “how much return does this strategy produce per unit of risk taken?”. It is computed by dividing excess return (strategy return minus the risk-free rate) by the standard deviation of returns, i.e. their volatility. Two strategies with the same annual return are not equally valuable if one achieves it through steady progress and the other through a rollercoaster: the former will show a markedly higher Sharpe.
Rules of thumb and limitations
The usual guideposts: a Sharpe below 1 is considered poor, between 1 and 2 decent, above 2 very good : indicative thresholds, sensitive to the period and calculation frequency. The ratio's main limitation is that it penalises upside volatility as much as downside: a strategy with explosive but irregular gains can show a modest Sharpe. In Screener.Trading, the backtest computes your strategy's Sharpe ratio, to be weighed against the maximum drawdown and equity curve for a full risk picture.
Frequently asked questions
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