Risk-Adjusted Performance: Sharpe, Sortino, Drawdown & Beyond
"I made 100% this year" sounds great until you learn about the 80% drawdown along the way. Raw returns are meaningless without risk context. This comprehensive guide teaches you to measure trading performance correctly using Sharpe ratio, Sortino ratio, maximum drawdown, profit factor, and Calmar ratio. Learn what good values look like, how to interpret each metric, and how to use them to improve your trading.
- Raw returns are misleading. Risk-adjusted metrics reveal true performance quality.
- Sharpe ratio = return per unit of volatility. Above 1 is good. Above 2 is excellent.
- Sortino ratio only penalizes downside volatility. Better for asymmetric strategies with big winners.
- Max drawdown = worst peak-to-trough decline. Critical for survival. 50% DD requires 100% to recover.
- Use multiple metrics together. No single number tells the whole story.
Performance Metrics Explorer
Click through different performance metrics to understand what they measure and what values to target:
Return per unit of total risk. The gold standard for risk-adjusted returns. Higher is better—you want maximum return for minimum volatility.
Interpretation
Sharpe of 1 = 1 unit return per unit risk. Sharpe of 2 = exceptional. Sharpe of 3+ = suspicious (check for data issues).
Good Values
> 1.0 (good), > 2.0 (excellent)
Bad Values
< 0.5 (poor), < 0 (losing money)
Why Raw Returns Are Misleading
Two traders both made 50% this year:
- Trader A: Steady gains, never down more than 10%, consistent monthly profits.
- Trader B: Wild swings, 60% drawdown at one point, lucky recovery.
Same return. Completely different quality. Trader A will likely repeat. Trader B got lucky and may blow up next time. Risk-adjusted metrics capture this difference.
The fundamental question: How much return per unit of risk? A strategy that makes 20% with 5% max drawdown is superior to one that makes 40% with 50% max drawdown—even though the second made more money.
The Sharpe Ratio
The gold standard of risk-adjusted returns. Created by Nobel laureate William Sharpe.
Formula
Sharpe = (Return - Risk-Free Rate) / Standard Deviation
Interpretation
- <0: Losing money. Stop trading this strategy.
- 0-0.5: Poor risk-adjusted returns. Barely better than random.
- 0.5-1: Below average but potentially salvageable.
- 1-2: Good. Most successful traders are here.
- 2-3: Excellent. Top-tier performance.
- >3: Suspicious. Verify data. May be curve-fitted or short sample.
Limitations
Sharpe penalizes all volatility equally—both upside and downside. If you have big winners and small losers (ideal), your Sharpe may look worse than it should. This is where Sortino helps.
The Sortino Ratio
Like Sharpe but only penalizes downside volatility. Recognizes that upside volatility is good.
Formula
Sortino = (Return - Risk-Free Rate) / Downside Deviation
When to Use
Sortino is better when your strategy has asymmetric returns—big winners, small losers. The upside doesn't penalize you. If your Sortino is significantly higher than Sharpe, it indicates positive skew (good).
| Metric | Good | Excellent | Measures |
|---|---|---|---|
| Sharpe Ratio | >1.0 | >2.0 | Return per total volatility |
| Sortino Ratio | >1.5 | >3.0 | Return per downside vol |
| Max Drawdown | <20% | <10% | Worst decline |
| Profit Factor | >1.5 | >2.0 | Gross profit/loss |
| Calmar Ratio | >1.0 | >3.0 | Return vs max DD |
Maximum Drawdown
The largest peak-to-trough decline before a new high. Measures worst-case scenario.
Why It Matters
Drawdown determines survival. A 50% drawdown requires 100% gain to recover. A 75% drawdown requires 300% gain. Large drawdowns are often unrecoverable—psychologically and mathematically.
Recovery Math
- 10% drawdown: Need 11% to recover
- 20% drawdown: Need 25% to recover
- 30% drawdown: Need 43% to recover
- 50% drawdown: Need 100% to recover
- 75% drawdown: Need 300% to recover
Guidelines
- <10%: Conservative, institutional-grade
- 10-20%: Moderate, acceptable for most
- 20-30%: Aggressive but manageable
- 30-50%: Dangerous, difficult recovery
- >50%: Near-fatal, likely blow up eventually
Other Essential Metrics
Profit Factor
Gross profit divided by gross loss. Simple but powerful.
Profit Factor = Gross Winning Trades / Gross Losing Trades
PF >1 = profitable. PF of 1.5 = $1.50 won for every $1 lost. PF of 2+ = strong edge.
Calmar Ratio
Annual return divided by max drawdown. How well compensated for the worst pain.
Calmar = Annual Return / Max Drawdown
Calmar of 2 means your annual return is 2x your worst drawdown. Higher = better.
Win Rate and Average Win/Loss
Win rate alone is meaningless. A 90% win rate with average win of $10 and average loss of $100 loses money. Combine with average win and average loss for full picture.
Expectancy = (Win Rate × Avg Win) - (Loss Rate × Avg Loss)
Frequently Asked Questions
What is risk-adjusted return?
Return relative to risk taken. A 50% return with 10% drawdown is better than 50% return with 40% drawdown. Risk-adjusted metrics capture this—raw returns don't. They answer: how much return per unit of risk?
What is the Sharpe ratio?
Return minus risk-free rate, divided by standard deviation. Measures return per unit of total volatility. Sharpe of 1 = 1 unit return per unit risk. Higher is better. Most important single metric.
What's a good Sharpe ratio?
Above 1 is good. Above 2 is excellent. Above 3 is exceptional (and should be verified—may indicate data issues or curve fitting). Below 0.5 is poor. Negative means losing money.
What is the Sortino ratio and how is it different from Sharpe?
Sortino only penalizes downside volatility, not total volatility. Upside volatility (big winners) is good—Sortino doesn't punish it. More relevant for asymmetric strategies with big winners.
What is maximum drawdown?
Largest peak-to-trough decline before recovery. If equity went from $100K to $60K to $120K, max drawdown is 40%. Critical metric—even great returns are worthless if drawdown wipes you out first.
What is profit factor?
Gross profit divided by gross loss. PF of 1.5 means you win $1.50 for every $1.00 lost. Above 1 = profitable. Above 2 = strong edge. Simple but powerful metric.
What is the Calmar ratio?
Annual return divided by max drawdown. Measures how well you're compensated for worst-case pain. Calmar of 2 means annual return is 2x your worst drawdown. Higher = better risk/reward.
Which metric is most important?
No single metric tells the whole story. Use multiple: Sharpe for efficiency, max drawdown for survival, profit factor for edge, Calmar for return vs pain. Together they reveal true performance.
How do I improve my risk-adjusted returns?
Three ways: increase returns (better entries, let winners run), reduce volatility (position sizing, diversification), or reduce drawdowns (stop losses, risk management). Most improvement comes from the latter two.
How much historical data do I need for reliable metrics?
Minimum 100 trades for basic statistics. 200+ for reliable Sharpe/Sortino. 1+ years for drawdown assessment. More data = more confidence. Metrics from 20 trades are meaningless.