What is Sharpe Ratio and how is it calculated?
Sharpe Ratio assesses the risk of an investment or trading strategy compared to its past or expected returns.
This ratio is calculated by subtracting the risk-free rates from the expected returns and dividing the result by the volatility/standard deviation of the former.
Sharpe Ratio aims to measure the consistency of returns and due to this emphasis, is heavily influenced by the standard deviation of monthly returns.
A higher Sharpe value demonstrates high consistency of returns month-over-month when compared to a lower Sharpe value strategy.
It's important to note that high-risk or volatile investments generally display a poor performance on this metric independently of their returns, as such, two strategies cannot be compared solely based on this ratio. It's rather a metric to help make an informed decision between 2 or more investments with similar returns.
Here's how we calculate Sharpe Ratio:
Typically, this ratio is calculated using annual values, but this method doesn't provide reliable results in cryptocurrency investments or trading strategies due to a lack of sufficiently lengthy market data. To solve this issue, we calculate Sharpe using monthly returns for increased accuracy.
We've also assumed a risk-free rate of 8% for our calculations based on the current lowest risk investment market offerings, stable-coin staking platforms such as Nexo, BlockFi, Celsius.
(Mean Monthly % Returns - Monthly Risk-free Rate (8%/12)) / Standard Deviation of returns.
We then annualize this value by multiplying it by √12.