Definition in one sentence: the Sharpe ratio measures a strategy's return above the risk-free rate, relative to its volatility — in other words, how much return you get for each unit of fluctuation endured.
The formula, and what it measures
The calculation is simple. You take the strategy's return, subtract the risk-free rate (what a risk-free investment would have returned over the same period), then divide by the volatility of those returns.
(return − risk-free rate) ÷ volatilityThe result is almost always annualised, to compare strategies observed over different durations. The underlying idea: a high return is only worth something relative to the risk it took to obtain it. Winning a lot on a permanent rollercoaster is worth less than winning less, calmly.
How to read it: good vs bad
There is no universal threshold, but widely accepted conventions:
| Sharpe ratio | Common reading |
|---|---|
| < 1 | Return poorly compensates the risk taken |
| 1 to 2 | Decent |
| 2 to 3 | Good |
| > 3 | Excellent — and worth double-checking |
That last line is not a joke. On very volatile markets such as crypto, an unusually high Sharpe over a short period is more often the sign of too small a sample or of overfitting than of hidden genius. A good reflex: always read the Sharpe with the maximum drawdown and the recovery time next to it.
The classic mistake
The most common one: treating the Sharpe as a final grade. It has a structural weakness — it penalises upside and downside volatility the same way. To the Sharpe, a sharp rise is as 'risky' as a sharp drop. Absurd from an investor's point of view: nobody ever complained about a gain.
The consequence: a strategy that climbs in bursts but almost never drops can show a mediocre Sharpe, while being excellent to live with. This is exactly what the Sortino ratio (which counts only downside volatility) and the Calmar ratio (which relates return to the worst loss endured) exist to fix. The Sharpe is a starting point, never the last word.
At Sextant
Sextant is a transparent quant platform: the guiding principle is to never reduce a strategy to a single number. The public logbook shows the Sharpe alongside the maximum drawdown, the recovery time and the abstention rate — because it is the whole picture, not the isolated ratio, that tells the truth about a system. The methodology details how these metrics are computed, fees and slippage included.
Frequently asked questions
What is a good Sharpe ratio?
By convention, a Sharpe above 1 is decent, above 2 good, above 3 excellent. These thresholds depend on the calculation window and the asset class. In crypto, which is very volatile, a Sharpe should always be read with the maximum drawdown and the recovery time alongside it — never on its own.
How is the Sharpe ratio calculated?
You subtract the risk-free rate from the strategy's return, then divide by the standard deviation (the volatility) of those returns. The result is generally annualised to allow comparison between strategies of different durations.
What is the limit of the Sharpe ratio?
It penalises upside and downside volatility the same way, whereas an investor only suffers from the downside. It is also blind to the depth and sequence of losses: two strategies with the same Sharpe can offer very different experiences. That is why it is complemented by the Sortino and Calmar ratios.