Using the Sharpe Ratio to Compare Trading Strategies and Their Risks
Summary
The article explains the Sharpe ratio as a way to compare a strategy’s average excess return with the variability of those returns. It describes annualizing the measure according to the return sampling interval, using a suitable benchmark, and treating dollar-neutral strategies differently because they are self-financing. Examples compare buy-and-hold equity returns with simple market-neutral long/short positions, showing how the calculation can be applied to daily price data.
The examples illustrate the metric rather than establish that a strategy is investable. The article cautions that Sharpe is backward-looking, assumes a return distribution that may understate fat-tail risk, and can make strategies with rare severe losses look attractive. Transaction costs should be reflected in net returns, and Sharpe should be considered alongside other measures such as drawdown. Benchmark choice also requires judgment, especially for market-neutral strategies. The article’s suggested Sharpe thresholds are presented as practical opinions, not universal standards; results depend on data, costs, period, and assumptions.
Key ideas
- Sharpe compares average excess returns with the volatility of those returns.
- Annualization must match the frequency of the return observations and the relevant trading calendar.
- Benchmark selection affects the interpretation of the ratio, with special treatment for self-financing market-neutral portfolios.
- Historical Sharpe can miss regime changes and underestimate risks from unusually large losses.
- Transaction costs belong in the net returns used to assess a strategy.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.