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Sharpe Ratio Explained: The Only Performance Metric That Matters
Raw returns are vanity. Risk-adjusted returns are sanity. The Sharpe ratio is the single number that separates a lucky run from a real edge.
SIGMASEVEN ResearchIn short
The Sharpe ratio measures excess return per unit of volatility. A strategy returning 40 percent with high volatility can be inferior to one returning 20 percent with low volatility. Sharpe normalises performance so that you can compare strategies honestly across different risk levels, timeframes, and asset classes.
What the Sharpe ratio actually measures
Sharpe equals annualised excess return divided by annualised standard deviation of returns. Excess return is the strategy return minus the risk-free rate. A Sharpe of 1.0 means you earn one unit of excess return for every unit of volatility you accept.
A Sharpe below 0.5 is generally considered poor. Above 1.0 is good. Above 2.0 is excellent and unusual outside of very short-term strategies or strategies with tail risks that are not captured in standard deviation.
Why raw returns mislead
A strategy that returned 120 percent in one year sounds extraordinary until you learn it had a 60 percent intra-year drawdown and a Sharpe ratio of 0.4. The same 120 percent achieved with a 15 percent maximum drawdown and a Sharpe of 2.1 is a fundamentally different proposition.
The Sharpe ratio is what prevents marketing from masquerading as performance. It forces the return to be contextualised against the risk taken to achieve it.
Sharpe ratio limitations
Sharpe penalises upside volatility equally with downside volatility. If a strategy occasionally produces massive wins, Sharpe will look artificially depressed. The Sortino ratio, which only penalises downside deviation, is a better metric for asymmetric strategies.
Sharpe also assumes normally distributed returns. In practice, crypto strategies often have skewed, fat-tailed return distributions. A strategy can have an attractive Sharpe and still produce catastrophic tail losses that the standard deviation does not reflect.
What a good Sharpe means for a Bitcoin strategy
Bitcoin buy and hold historically produces a Sharpe ratio of approximately 0.6 to 0.9 over full cycles. A systematic strategy worth following should produce a Sharpe materially above passive Bitcoin exposure - typically 1.2 or above - while also reducing maximum drawdown.
Any provider that publishes returns without a Sharpe ratio (or its equivalent) is either not computing it or does not want you to. Both are informative signals. All of our strategies publish full risk-adjusted metrics including Sharpe and maximum drawdown alongside raw returns.
Frequently asked questions
- What is the Sharpe ratio?
- The Sharpe ratio is the annualised excess return of a strategy divided by its annualised return volatility. It measures how much return you receive per unit of risk taken.
- What is a good Sharpe ratio for a trading strategy?
- A Sharpe ratio above 1.0 is considered good. Above 2.0 is excellent. Below 0.5 suggests the strategy is not generating meaningful risk-adjusted returns.
- What is the difference between Sharpe and Sortino?
- Sharpe uses total return volatility (both up and down). Sortino uses only downside deviation. Sortino is more appropriate for strategies with positive skew, where upside volatility is desirable.
- How do I calculate the Sharpe ratio?
- Subtract the risk-free rate from your annualised return, then divide by the annualised standard deviation of your returns. Most quantitative platforms calculate this automatically from trade history.