The Sharpe ratio measures how much excess return a portfolio generates for each unit of total risk (volatility) it takes. Because Sharpe ratio uses total volatility (both upside and downside), it assumes that all volatility is equally undesirable. This makes the Sharpe ratio simple and widely used, but less precise for portfolios with asymmetric risk profiles, such as those containing options. If your portfolio contains options, the Sortino ratio can be a better measure to use.
How is the Sharpe Ratio calculated?
The Sharpe ratio measures the returns on an Account, in comparison to the risk taken to achieve those returns. It informs on the excess returns earned over and above a risk-free rate (best risk-free alternative to investing such as holding cash). SAXO BANK uses a risk-free rate of zero and calculates Sharpe Ratio for a period of at least 6 months. As the Sharpe ratio is a reward-to-risk ratio, the Account performance is risk-adjusted. This means that the excess returns earned over the risk-free rate are measured in relation to the risk (standard deviation) of the Account. The Sharpe ratio is calculated as:
Assume a realised return of 6% and a risk-free rate of 0%, with a standard deviation of 4.04%. The Sharpe ratio for the period is:
A high Sharpe ratio (above or equal to 1.0) indicates that the returns for the period were high (or 'good') relative to the risk taken in the period.
When to use the Sharpe Ratio
The Sharpe ratio is most useful when risk can be reasonably summarized by volatility and returns behave in a relatively stable, predictable way. In practice, it works best in the following situations:
- Comparing portfolios or funds with similar risk characteristics
- Evaluating strategies with roughly symmetric, normally distributed returns
- Measuring risk‑adjusted returns for traditional, liquid portfolios (stocks, bonds, diversified funds)
Read also: What is the Sortino Ratio?