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.
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.
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.
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.
Weekly, Monthly, Quarterly review periods
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.
Fixed-fractional position sizing risks a fixed percentage of your account on every trade (commonly 1-2%). This ensures that a string of losses reduces position sizes proportionally, protecting capital during drawdowns. It's the most widely recommended position sizing method for discretionary traders because it's simple, sustainable, and mathematically sound.
The Kelly Criterion is a mathematical formula for determining the optimal bet size to maximise long-term growth rate. Kelly = (bp - q) / b, where b = odds received, p = probability of winning, q = probability of losing. While theoretically optimal, full Kelly is too aggressive for most traders — half-Kelly or quarter-Kelly is more practical.
The risk-reward ratio (R:R or RRR) compares the potential loss (distance to stop loss) to the potential gain (distance to target) for each trade. A 1:2 R:R means you risk $1 to potentially make $2. By maintaining favourable risk-reward ratios, a trader can be profitable even with a win rate below 50%.
Portfolio diversification reduces risk by spreading capital across multiple uncorrelated or negatively correlated assets, strategies, and timeframes. True diversification requires correlation analysis — holding 10 tech stocks is not diversified. The goal is to generate returns from multiple independent sources rather than relying on a single trade or strategy.