How it works
Sharpe = (Strategy Return − Risk-Free Rate) / Standard Deviation of Returns. The risk-free rate is typically a short-term Treasury yield. Standard deviation is computed on the same periodicity as the returns (daily, weekly, monthly). To annualise a Sharpe from daily returns, multiply by the square root of 252. A Sharpe of 1.0 is decent; 2.0 is very good; 3.0 is rare and typically signals data error or overfit.
Example
Strategy A delivers 15 percent annual return with 20 percent annual volatility. Risk-free rate is 4 percent. Sharpe = (15 − 4) / 20 = 0.55. Strategy B delivers 10 percent return with 8 percent volatility. Sharpe = (10 − 4) / 8 = 0.75. B beats A on risk-adjusted basis even though A has higher absolute return. With leverage, B can be levered to match A’s volatility while retaining its risk-adjusted edge.
Why it matters
Comparing strategies by absolute return alone systematically rewards excessive risk-taking. Sharpe forces an apples-to-apples comparison. The catch: Sharpe penalises upside volatility equally with downside, which can disadvantage strategies with positive skew. For tail-heavy strategies, also look at Sortino ratio (downside-only volatility) or maximum drawdown. Sharpe is the starting point, not the final word.
