Sharpe Ratio

The Sharpe ratio is a measure of risk-adjusted return that indicates how much excess return an investment generates per unit of risk taken. It is calculated by dividing the average return in excess of the risk-free rate by the standard deviation of returns. A higher Sharpe ratio indicates better risk-adjusted performance.

If a trading strategy generates an average annual return of 20% while the risk-free rate is 4%, and the standard deviation of those returns is 12%, the Sharpe ratio would be 1.33. In a prop trading context, the Sharpe ratio is a valuable performance metric because it rewards consistency — a strategy with moderate returns and low volatility can have a higher Sharpe ratio than one with higher returns but significant drawdowns. Prop firms and performance analysts often use the Sharpe ratio to evaluate whether a trader's results are the product of skill or excessive risk-taking.