Using Sharpe and Sortino Ratios to Compare Trading Risk and Return

Summary

The article explains the Sharpe ratio as average return above a risk-free rate divided by return standard deviation. It outlines how to compute periodic returns and dispersion, and how to annualize ratios from shorter timeframes using the square root of the number of periods. A zero risk-free rate is offered as a practical simplification when comparing strategies over the same interval.

Examples use EURUSD prices and describe applying a custom Sharpe criterion in strategy optimization. The article reports that the highest-Sharpe passes did not necessarily have the highest profit, but tended to have smoother equity curves with smaller falls. It also introduces Sortino as a related risk-adjusted measure, though the provided text gives little detail on its calculation. Ratios are useful for comparing strategies and portfolios, but their interpretation is limited because the standard approach assumes normally distributed returns, an assumption that often fails in financial markets.

Key ideas

• Sharpe compares excess average return with the variability of returns.
• Periodic asset returns can be computed from successive closing values and aggregated over a chosen horizon.
• Annualization scales a shorter-period Sharpe ratio by the square root of the number of periods in a year.
• Sharpe-based optimization can favor smoother equity curves even when those settings do not maximize profit.
• The normal-distribution assumption limits how confidently Sharpe and related ratios describe real trading risk.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.