Using the Sharpe Ratio to Compare Trading Strategy Returns and Risk

Summary

This article explains the Sharpe ratio as a way to compare excess returns with their variability, making it more informative than annualized return alone when strategies have different risk profiles. It describes annualizing the measure according to the frequency of the return observations and stresses that the benchmark must fit the strategy. Examples include using a government rate for a long-only equity investment and a market-neutral long-short comparison that excludes the risk-free rate under the article’s self-financing assumption.

The article illustrates the calculation with historical buy-and-hold and market-neutral equity examples, reporting Sharpe values for two stocks in each setup. It warns that the measure is backward-looking, can understate risks from fat-tailed returns, and may reward strategies with rare severe losses. Transaction costs should be included in net returns, and the ratio should be considered alongside drawdown and other risk measures. Its suggested Sharpe thresholds are presented as practical heuristics, not universal guarantees.

Key ideas

• The Sharpe ratio relates average benchmark-adjusted returns to return volatility.
• Annualization depends on the number of trading periods represented in the return series.
• Benchmark selection should reflect the strategy, including whether it is market-neutral.
• Historical Sharpe can miss regime shifts and tail risk.
• Transaction costs and other risk measures must inform strategy evaluation.

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