Sharpe & Sortino Ratios
Overview
The Sharpe ratio measures risk-adjusted return by dividing excess return (above the risk-free rate) by the standard deviation of returns. The Sortino ratio improves on Sharpe by penalising only downside deviation, recognising that upside volatility is desirable. Both ratios help traders compare strategies on a level playing field and identify which approaches deliver the best returns for their level of risk.
Key Concepts
Sharpe ratio equals excess return divided by total standard deviation of returns. Sortino ratio equals excess return divided by downside standard deviation only. A Sharpe above one is generally considered acceptable, above two is very good. Sortino is preferred for strategies with asymmetric return profiles, such as trend following. Both ratios are annualised for comparison across different time horizons. Neither ratio captures tail risk or maximum drawdown, so they should be used alongside other metrics.
Entry Signals
Use Sharpe and Sortino ratios during strategy development to evaluate edge quality. Compare ratios across different parameter settings to find robust configurations. A rising Sharpe ratio during walk-forward testing suggests genuine edge. Allocate more capital to strategies with higher risk-adjusted returns.
Exit Signals
Reduce allocation if the rolling Sharpe ratio drops below a pre-defined threshold. Halt a strategy if the Sortino ratio turns negative over a meaningful sample size. Compare live performance ratios to backtested expectations — significant degradation signals regime change. Review and potentially retire strategies with persistently declining ratios.
Best Timeframes
Weekly, Monthly, Quarterly review periods
Pro Tips
A high Sharpe ratio from backtesting does not guarantee future performance — always verify with out-of-sample and walk-forward testing. The Sortino ratio is generally more useful for traders because it does not penalise large winning trades. Aim for a Sortino ratio of at least one point five for any strategy you intend to trade with meaningful capital.
More Topics in This Category
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Fixed-Fractional Position Sizing
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