Sharpe ratio

The Sharpe ratio is the average return of a rule above the risk-free rate, divided by the volatility of those returns. It measures return per unit of variability.

How Sharpe ratio is calculated

Sharpe = (mean return - risk-free rate) / standard deviation of returns, usually from daily returns multiplied by the square root of 252 to annualise. A Sharpe of 1 means the average excess return equals one standard deviation per year. Selecting the best of many rules inflates the best one's Sharpe, which the Deflated Sharpe Ratio corrects for.

How it is read

Higher is better when comparing rules with similar exposure. It treats up and down swings alike and assumes returns are roughly normal.

Common mistakes

• Quoting the best Sharpe from many tries without adjusting.
• Comparing across different return frequencies without annualising the same way.
• Using it on a strategy with rare large losses, where it understates the risk.

What Tickfloor tested

Tickfloor's research desk has backtested 678 strategies, net of modelled trading costs. After correcting for the 761 tests run, 0 passed. That does not prove no strategy works. These are historical diagnostics, not validation under Testing Standard v2: the backtest harness predates that standard and has not been re-run to meet it.

• How lucky is our best result? (study)

Lessons that cover it

• Why testing many ideas finds lucky ones

• Short definition in the glossary

Related concepts

• Multiple testing
• Volatility
• Drawdown
• Benchmark
• All concepts

General information only. It doesn't consider your objectives, finances or needs. Tickfloor holds no financial services licence and never places trades.

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