Master the essential metrics that determine strategy quality. Learn Sharpe ratio, Sortino, maximum drawdown, profit factor, and how to interpret them correctly.
The overall percentage gain or loss from start to finish.
Formula:
Total Return = (Final Value - Initial Value) / Initial Value × 100%
Example
Started with $10,000, ended with $15,000 → Total Return = ($15,000 - $10,000) / $10,000 = 50%
Compound Annual Growth Rate - normalizes returns across different time periods. More useful than total return for comparing strategies.
Formula:
CAGR = (Final Value / Initial Value)^(1/Years) - 1
Example
$10K → $15K over 2 years
CAGR = ($15,000 / $10,000)^(1/2) - 1 = 22.5% annually
Always use CAGR when comparing strategies. A 100% return over 5 years (14.9% CAGR) is worse than 80% over 2 years (34.2% CAGR). CAGR accounts for time and compounding.
Measures return per unit of volatility. Higher is better. Shows how much excess return you receive for the volatility you endure.
Formula:
Sharpe Ratio = (Return - Risk Free Rate) / Standard Deviation
| Sharpe Ratio | Rating | Interpretation |
|---|---|---|
| < 1.0 | Poor | Low return for risk taken |
| 1.0 - 2.0 | Good | Acceptable risk-adjusted returns |
| 2.0 - 3.0 | Excellent | Strong risk-adjusted returns |
| > 3.0 | Exceptional | Institutional-grade |
Real Example
Like Sharpe but only penalizes downside volatility. Better for strategies with asymmetric returns.
Formula:
Sortino = (Return - Risk Free Rate) / Downside Deviation
Only counts negative volatility, ignores positive swings
When to prefer Sortino:
Strategies with big wins, small losses (upside volatility is good)
When to prefer Sharpe:
Balanced strategies with symmetric returns
Largest peak-to-trough decline in account value. Shows worst-case loss you must tolerate.
Formula:
Max DD = (Trough Value - Peak Value) / Peak Value × 100%
Example: Peak $15K, Trough $10K → Max DD = -33.3%
| Max Drawdown | Rating | Psychological Impact |
|---|---|---|
| < 10% | Excellent | Easy to tolerate |
| 10-20% | Good | Manageable stress |
| 20-30% | Moderate | Significant stress |
| 30-50% | High | Severe stress, may quit |
| > 50% | Extreme | ❌ Unacceptable for most |
Recovery Math
Return per unit of maximum drawdown. Higher is better.
Formula:
Calmar = Annualized Return / |Max Drawdown|
Example: 20% CAGR, 15% max DD → Calmar = 1.33
Values > 1.0 are good (return exceeds max drawdown). Values > 2.0 are excellent.
Percentage of trades that are profitable. Simple but misleading if viewed alone.
Formula:
Win Rate = (Winning Trades / Total Trades) × 100%
Win Rate Can Be Misleading
Ratio of gross profit to gross loss. Shows dollars made per dollar lost.
Formula:
Profit Factor = Gross Profit / Gross Loss
Example: $12,000 in wins, $8,000 in losses → PF = 1.5
| Profit Factor | Interpretation | $ Made per $ Lost |
|---|---|---|
| < 1.0 | ❌ Losing | Net loss |
| 1.0 - 1.5 | Marginal | $1.00-$1.50 per $1 lost |
| 1.5 - 2.0 | Good | $1.50-$2.00 per $1 lost |
| 2.0 - 3.0 | Excellent | $2.00-$3.00 per $1 lost |
| > 3.0 | Exceptional | >$3.00 per $1 lost |
Shows risk/reward ratio of your trades. Critical for evaluating strategy quality.
Net profit divided by max drawdown.
Recovery = Net Profit / |Max DD|
Values > 2.0 are good. Shows if profits justify the pain.
Average $ expected per trade.
= (Win% × Avg Win) - (Loss% × Avg Loss)
Positive = profitable. Higher is better.
Longest losing streak in backtest.
Important for position sizing. If max = 8 losses, expect 10-12 in live trading (multiply by 1.5×).
Measures depth and duration of drawdowns.
Lower is better. More comprehensive than max drawdown alone.
Returns:
Risk:
→ Strong returns with manageable risk. Good Sharpe shows consistency. Low drawdown = low stress.
Returns:
Risk:
→ High returns but terrible risk metrics. Sharpe < 1 and 42% drawdown means extreme volatility. Most traders would quit during drawdown.
A Sharpe ratio above 1.0 is considered good, above 2.0 is excellent, and above 3.0 is exceptional. It measures risk-adjusted returns. Sharpe of 1.5 means you earn 1.5 units of return for each unit of volatility. Most successful strategies have Sharpe ratios between 1.0-2.5.
Maximum drawdown is the largest peak-to-trough decline in account value. If your account grew from $10K to $15K, then dropped to $12K, max drawdown is $3K or 20% from the peak. Lower is better. Professional strategies target max drawdown under 20-30%.
Profit factor = Gross Profit / Gross Loss. It shows how many dollars you make for each dollar lost. Profit factor of 2.0 means you make $2 for every $1 lost. Values above 1.5 are good, above 2.0 are excellent. Below 1.0 means the strategy loses money.
Yes, but it indicates high volatility. Example: 50% return with 60% volatility gives Sharpe of 0.83 (poor). This strategy has wild swings and is psychologically difficult. Compare to 20% return with 10% volatility (Sharpe 2.0) - lower returns but much smoother, sustainable equity curve.