The Sortino Ratio: A Better Risk Measure for Traders?

The Sharpe ratio penalizes all volatility, including big winning days. For most traders, upside volatility is welcome. The Sortino ratio, developed by Frank Sortino, only counts the volatility that hurts: returns below a target.

The formula

Sortino ratio = (Average return − Target return) ÷ Downside deviation

The target is often zero or the risk-free rate. Downside deviation is calculated like a standard deviation, but only from returns below the target, with returns above it counted as zero.

Steps

1. Take your daily returns.
2. For each day, compute min(0, return − target).
3. Square those values, average them over all days, and take the square root. That is the downside deviation.
4. Divide your average excess return by it.
5. Annualize by multiplying by √252 for daily data.

Sharpe vs Sortino

For a strategy with occasional large winners and small, controlled losses, such as trend following, the Sortino ratio is usually much higher than the Sharpe ratio, and arguably fairer.

When it can mislead

• Few losing days in the sample. Downside deviation is then estimated from very little data and can be unreliable.
• Rare, large losses. Strategies that collect small gains and occasionally take a huge loss may look excellent until that loss happens. See loss aversion.

Using both

Comparing the two is informative. If your Sortino is much higher than your Sharpe, your volatility comes mostly from winning days, which is good. If they are close, your losses are a large part of your volatility. Combine them with maximum drawdown for a full picture.

In TradeThink

Both ratios are on the statistics page, calculated from your daily returns, with metric history to see how they change. Related: the Sharpe ratio for traders.