The Sharpe ratio is a measure of risk-adjusted return: a portfolio’s return above the risk-free rate, divided by the standard deviation of its returns. Introduced by economist William F. Sharpe, it expresses how much excess return an investment generates per unit of volatility taken to earn it.
Its value is in comparison. Two strategies can both return 12% a year, but if one does it with half the volatility, it has double the Sharpe ratio — the same destination with a far smoother ride, which also means it can be leveraged or sized more safely.
The ratio has known blind spots: it penalizes upside volatility just as harshly as downside, understates the risk of strategies with rare large losses, and shifts with the measurement period. Treat it as one lens alongside maximum drawdown and trade-level expectancy, not a verdict.
A strategy returns 12% annually with 10% volatility of returns while the risk-free rate is 4%: (12 − 4) ÷ 10 = 0.8.