Sharpe ratio
How do you judge whether a return was worth the price swings you had to sit through?
In plain words
The Sharpe ratio divides a return in excess of a risk-free rate by the volatility of that return, so a gain is expressed per unit of risk rather than in isolation. A higher value means more excess return for each unit of price swing.
Why it matters
Comparing raw returns alone rewards any market that simply moved a lot. Dividing by volatility separates a steady gain from a wild one, and shows whether the outcome was large relative to the disturbance a position had to absorb along the way.
In a real week: ETH, week of 10 June 2019
In the week of 10 June 2019, ETH rose 15.89% while its annualised realised volatility was 64.2%. The return sat in the 91.0 percentile of its 69 weeks of history, yet the week's range was 22.04% and the largest hourly move 3.78%. The gain was large against the volatility it took to earn it, though one week is a thin sample.
A common mistake
Reading a high Sharpe ratio as a forecast. It describes past return against past volatility and can collapse quickly if volatility rises.