Crypto glossary
Sharpe ratio
The Sharpe ratio measures return per unit of risk: an investment's return above the risk-free rate divided by the volatility of its returns.
Created by economist William Sharpe, the ratio subtracts a risk-free rate, typically short-term government bills, from an asset's return and divides the result by the standard deviation of returns. A higher figure means more return for each unit of volatility. Values are usually annualised so that funds and strategies can be compared.
In crypto the ratio is used to compare bitcoin with stocks or gold, to evaluate funds and trading strategies and to judge whether adding crypto improves a portfolio. Because bitcoin has delivered high returns with very high volatility, its Sharpe ratio has swung widely depending on the period chosen, sometimes looking excellent and sometimes poor.
The measure treats upside and downside swings as equal risk and assumes returns are roughly normally distributed, which crypto's fat-tailed, crash-prone behaviour violates. A short track record or a strategy that sells tail risk can show an attractive Sharpe until a single event erases it. Variants like the Sortino ratio penalise only downside volatility.
Example
Two crypto funds both returned 40% last year. One had annualised volatility of 80%, the other 40%, so with a 4% risk-free rate their Sharpe ratios are about 0.45 and 0.9.