Sharpe Ratio

The Sharpe ratiomeasures how much excess return a strategy earns per unit of volatility. Two systems with the same annual return aren’t equally good if one of them gets there with calm monthly gains and the other with violent swings. Sharpe is the standard way to tell them apart.

Formula: Sharpe = (Strategy Return − Risk-Free Rate) ÷ Standard Deviation of Returns. The risk-free rate in India is usually the 10-year G-Sec yield (around 7%). Standard deviation is computed on the period-by-period returns - daily, weekly, or monthly - and then annualized.

What Sharpe rewards (and what it doesn’t)

Sharpe rewards smoothness. A system that makes 1% every month gets a stellar Sharpe. A system that makes 30% in two months and breaks even the rest of the year gets a mediocre one - even if the total return is identical. For a discretionary trader, this matters because smooth equity curves are easier to scale with leverage and easier to hold during losing streaks.

The fair critique

Sharpe treats upside volatility and downside volatility the same. A strategy that suddenly makes a +50% month gets penalizedon Sharpe - even though most traders would happily take it. That’s why some funds report Sortino ratioinstead, which only penalizes downside deviation. Sharpe is also unreliable on small samples (<3 years of data) and on strategies with fat-tailed return distributions (most options strategies).

When it’s most useful

Comparing two strategies on the same instrument, same period, same return profile. Less useful for comparing a quiet pair-trader to a volatility-arbitrage shop - they don’t live on the same return distribution. As a single number for a single retail trader: it’s a fine sanity check, not a verdict.