Sharpe ratio in gold trading

The Sharpe ratio is the average excess return of a strategy (its return minus the risk-free rate, such as Treasury bills) divided by the standard deviation of those returns. It is usually quoted on an annual basis. A higher Sharpe means more return per unit of volatility.

How it applies to gold trading

The Sharpe ratio lets you compare a gold trading strategy with simply holding gold, holding stocks or holding cash. Gold itself has historically had a modest Sharpe because its returns are volatile relative to its long-run gains. A trading strategy that earns similar returns with much smaller swings will show a higher Sharpe.

The ratio treats upside and downside volatility the same and assumes returns are roughly normal, which trading returns are not: gold strategies often have fat tails around news. A short-volatility or martingale system can show a high Sharpe until a single event erases it. Read Sharpe together with maximum drawdown and the shape of the equity curve.

Worked example

Example (hypothetical numbers): a strategy returned 18% in a year with monthly returns that annualize to a standard deviation of 12%. With a risk-free rate of 4%, Sharpe = (18 − 4) ÷ 12 = 1.17. A second strategy returning 25% with 30% volatility has a Sharpe of 0.70, more return but less per unit of risk.

A common mistake

Calculating Sharpe on daily returns and forgetting to annualize, or comparing it across periods with different risk-free rates.

See also: Recovery factor, Volatility, Drawdown, Equity curve.

Frequently asked questions