The Sharpe Ratio is the most widely used measure of risk-adjusted return. It tells you how much excess return you're getting for each unit of risk taken.
In Simple Terms: Sharpe Ratio answers the question: "Is the return worth the risk?" A higher Sharpe means you're getting more return per unit of risk.
The Formula
Sharpe Ratio = (Strategy Return - Risk-Free Rate) / Standard Deviation Example: Strategy Return: 20% Risk-Free Rate: 6% (FD rate in India) Standard Deviation: 10% Sharpe = (20% - 6%) / 10% = 1.4
How to Interpret Sharpe Ratio
| Sharpe Ratio | Interpretation | Action |
|---|---|---|
| < 0 | Losing money | Don't trade this strategy |
| 0 - 1.0 | Poor risk-adjusted returns | Consider improvements |
| 1.0 - 2.0 | Good | Acceptable for trading |
| 2.0 - 3.0 | Very good | Strong strategy |
| > 3.0 | Excellent (verify carefully) | May be too good — check for errors |
Why Sharpe Ratio Matters
Consider two strategies:
| Metric | Strategy A | Strategy B |
|---|---|---|
| Annual Return | 25% | 25% |
| Volatility | 10% | 40% |
| Sharpe Ratio | 1.9 | 0.48 |
Both return 25%, but Strategy A is clearly better — same return with much less risk.
The Catch: Sharpe Ratio assumes returns are normally distributed, which isn't always true. It can't distinguish between upside volatility (good) and downside volatility (bad).
Limitations of Sharpe Ratio
- Assumes normal distribution: Markets have fat tails (extreme events)
- Penalizes upside volatility: Big gains count as "risk"
- Can be manipulated: Infrequent trading can inflate Sharpe
- Time-period dependent: Different periods give different Sharpes
Pro Tip: Look at Sharpe Ratio alongside Maximum Drawdown. A strategy can have good Sharpe but still have gut-wrenching drawdowns.
Practical Guidelines
- Compare strategies using the same time period
- A Sharpe of 1.0+ is generally acceptable for retail traders
- Don't chase extremely high Sharpe ratios — likely overfit
- Use Sharpe as one metric among many, not the only one
In VivaTrades
VivaTrades calculates Sharpe Ratio automatically for every backtest, using Indian risk-free rates. Compare multiple strategies to find the best risk-adjusted returns.