What Is Sharpe Ratio?
The Sharpe Ratio measures risk-adjusted returns by dividing the excess return (strategy return minus risk-free rate) by the standard deviation of returns. A Sharpe Ratio of 2.0 means you earned 2 units of return for every unit of risk. Higher is better — anything above 1.0 is generally acceptable, above 2.0 is excellent.
How Sharpe Ratio Works
Formula: Sharpe = (Strategy Return - Risk-Free Rate) / Standard Deviation of Returns. In crypto, the "risk-free rate" is typically the stablecoin yield or 0%. The Sharpe Ratio penalizes strategies with high volatility, even if they're profitable — a 100% return with 200% volatility has a worse Sharpe than a 20% return with 10% volatility.
Why It Matters for Traders
Sharpe Ratio is the industry-standard metric for comparing strategies. However, it has limitations in crypto: it assumes returns are normally distributed (crypto returns have fat tails), and it penalizes upside volatility equally with downside volatility. The Sortino Ratio (which only penalizes downside deviation) is often more appropriate for crypto strategies.
