Is a higher Sharpe ratio always better?
Generally yes, but not in isolation. A very high Sharpe ratio can result from strategies with limited data, survivorship bias, or returns that don't follow normal distributions. It also doesn't account for liquidity, maximum drawdown, or how long losing streaks last. Compare Sharpe ratios within the same asset class and timeframe, and always look at other metrics like Sortino ratio, maximum drawdown, and win rate to get the full picture.
How is Sharpe ratio different from win rate?
Win rate tells you what percentage of your trades are profitable, but says nothing about the size of wins versus losses or consistency. Sharpe ratio measures risk-adjusted return: it accounts for both your average gain and how volatile those gains are. You can have a 70% win rate but a poor Sharpe ratio if your losses are huge, or a 40% win rate with a strong Sharpe ratio if your winners far outweigh your losers and returns are steady.
What's the risk-free rate and why does it matter?
The risk-free rate is the return you could earn on a virtually zero-risk investment, typically the yield on short-term government bonds like U.S. Treasury bills. It represents the baseline return available without taking market risk. Subtracting it from your trading returns isolates the "excess return" you earned by taking on risk. When risk-free rates rise, your Sharpe ratio can fall even if your absolute returns stay the same, because you're being compared to a higher baseline.
Can Sharpe ratio be negative?
Yes. A negative Sharpe ratio means your average return is below the risk-free rate: you would have been better off in Treasury bills than taking on the volatility of your strategy. It signals that risk is not being rewarded. A strategy with a negative Sharpe ratio is losing money on a risk-adjusted basis and should be re-evaluated or abandoned unless there's a short-term drawdown you're willing to ride out.
Does Sharpe ratio work for all trading styles?
It's useful across styles but has limitations. For strategies with asymmetric return profiles—like options selling, where you collect small premiums most of the time but face rare large losses—Sharpe ratio can look deceptively strong until a tail event hits. It also assumes returns are normally distributed, which isn't true for many real trading strategies. For these cases, complement Sharpe ratio with metrics like Sortino ratio (which penalizes only downside volatility) and maximum drawdown to capture risk more fully.
