How the Sharpe ratio works
The Sharpe ratio measures return per unit of risk. It takes a strategy’s return above the risk-free rate and divides by its volatility, so a higher number means more reward for each unit of risk taken. It lets you compare a calm 8% strategy against a wild 20% one on equal terms, because raw return alone hides how much stomach-churning volatility produced it.
Worked example
Strategy A returns 12% with 10% volatility; Strategy B returns 18% with 30% volatility. Assuming a 2% risk-free rate, A’s Sharpe is (12-2)/10 = 1.0, while B’s is (18-2)/30 = 0.53. Strategy A is the better risk-adjusted performer despite the lower headline return, because it earned its gains far more smoothly. The bigger number is not automatically the better strategy.
Why Sharpe rewards smoothness
A high Sharpe ratio means steady, repeatable returns rather than a few lucky spikes, which is exactly what survives real-money trading and real drawdowns. On Volity, judge any approach across shares, forex, or crypto by its Sharpe, not its best month. A Sharpe above 1 is good, above 2 is excellent, and anything boasting huge returns with a low Sharpe is carrying hidden risk.
Why it matters
Sharpe is the standard way to compare strategies fairly, and it exposes the ones whose returns came purely from oversized risk that will eventually blow up. Always read return next to the volatility that produced it. Related: risk-reward ratio and alpha.
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