Guide · Risk Management
What Is a Sharpe Ratio? Measuring Return Against the Risk Taken
A big return alone doesn't tell you if a strategy was actually good. The Sharpe ratio asks the question that matters more: how much risk did it take to get there?
The Sharpe ratio measures how much return a strategy or portfolio generated per unit of risk taken, calculated by subtracting a risk-free rate (typically a short-term government bond yield) from the return, then dividing by the standard deviation of those returns — a common measure of how volatile the ride was along the way.
The reason it matters: two strategies can post the exact same headline return over a year while being nothing alike underneath. One might climb in a smooth, steady line; the other might get there via wild swings that would have shaken out most people holding it. Raw return treats both as identical successes. The Sharpe ratio doesn't — the smoother strategy scores higher because it delivered similar reward for meaningfully less volatility along the way.
As a rough reference point, a Sharpe ratio above 1 is generally considered decent, above 2 is very good, and above 3 is exceptional and rare over long periods — though the 'right' bar shifts depending on asset class and time frame, so it's most useful for comparing strategies against each other rather than against a single universal cutoff.
It's not a perfect measure — it treats upside and downside volatility the same, even though most traders only actually mind the downside — but as a single number for comparing two approaches on a risk-adjusted basis, it's one of the most widely used shorthand tools in the industry, and worth calculating on a strategy's paper-trading results before ever risking real capital on it.