Sharpe, Sortino and Profit Factor: Handy Numbers With Blind Spots

[Shadow Trader]

Risk-adjusted metrics compress an equity curve into a single figure, which is convenient and also hazardous. Each one answers a narrow question and hides others.

The Sharpe ratio divides average excess return by the standard deviation of returns. It penalises upside and downside swings equally, which is odd for a trader who welcomes large winning days. It also assumes returns are roughly symmetric, an assumption that strategies with occasional large losses, such as those holding losers, violate. A smooth record from selling tail risk can show an impressive Sharpe until the tail arrives.

Sortino addresses part of this by using only downside deviation, though the target return chosen changes the result, and small samples make the figure unstable.

Profit factor, gross profit divided by gross loss, is easy to read but ignores trade count and the order of results. A high value from thirty trades carries far less weight than a modest value from several hundred, and a single outlier win can inflate it.

None of these captures drawdown depth, duration or the cost of execution unless the underlying data includes them. Used together, with sample sizes stated and drawdown reported alongside, they are informative. Used alone, any one of them can make a fragile system look robust.