Risk-Adjusted Efficiency

The return your portfolio generated above what market exposure alone would predict, using the Capital Asset Pricing Model (CAPM) as the baseline:

α = Rₚ - left[Rf + β(Rₘ - Rf)right]

where Rₚ is portfolio return, Rf is the risk-free rate, Rₘ is market return, and β is the portfolio's market sensitivity.

How to use it: Positive alpha is evidence that your active management is adding genuine value beyond what you'd get from passive market exposure. Zero alpha means your returns are fully explained by your market beta — you're earning market return but not more. Negative alpha means the market itself is outperforming your strategy on a risk-adjusted basis, which is the clearest possible signal to reassess the approach.

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A measure of risk-adjusted return — specifically, how much excess return you earned per unit of total volatility. Formally:

S = (Rₚ - Rf) / (σₚ)

where Rₚ is your portfolio return, Rf is the risk-free rate, and σₚ is the standard deviation of your returns.

How to use it: A Sharpe above 1.0 is generally acceptable for retail portfolios; above 2.0 is strong for active trading. The key caveat: Sharpe penalizes all volatility equally, including upside volatility. For strategies with positively skewed returns (rare large winners), this can make performance look worse than it actually is. Always read Sharpe alongside the Sortino Ratio.

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A refinement of the Sharpe Ratio that only penalizes downside deviation — volatility that actually hurts you:

Sd = (Rₚ - Rf) / (σd)

where σd is the standard deviation of negative returns only.

How to use it: This is often the more meaningful metric for options traders and credit spread sellers, where the goal is to avoid large losses rather than smooth out all variance. A strategy with many small wins and occasional large losses will typically show a better Sortino than Sharpe — which is expected and appropriate. If your Sortino is significantly higher than your Sharpe, your return distribution is positively skewed, which is a good sign.

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Measures the consistency of your excess return over SPY:

IR = frac{Rₚ - Rb}{σₚ₋b}

where Rb is the benchmark return and σₚ₋b is the active risk — the standard deviation of your active returns relative to the benchmark.

How to use it: A high Information Ratio means you are generating alpha reliably, not just occasionally. A value above 0.5 is generally considered good for active strategies. This is a critical distinction from raw alpha: a strategy that outperforms SPY by 10% in one great year and underperforms by 8% in the next has positive average alpha but a low Information Ratio — suggesting luck plays a significant role. Consistent, repeatable outperformance is what a high IR reveals.

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A summary view of the statistical characteristics of your return stream, including standard deviation, annualized volatility, and skewness. High volatility means your equity curve is "noisy" — daily swings are large relative to your average return.

How to use it: Volatility is not inherently bad, but it should be proportional to the returns being generated — which is exactly what the Sharpe and Sortino Ratios measure. For credit spread traders, the target is typically low realized volatility relative to premium collected. High volatility in a credit strategy often signals oversizing, poor strike selection, or exposure to tail events. Pay particular attention to skewness: a negatively skewed return stream (rare large losses, frequent small gains) is expected for premium sellers, but the magnitude of those left-tail events must be managed carefully.

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Measures the volatility (standard deviation) of the difference in returns between your portfolio and the benchmark over time. It is the annualized standard deviation of active returns:

ActiveRisk = σ(Rₚ - Rb) × sqrt{252}

where Rₚ is the portfolio return and Rb is the benchmark return for each aligned daily observation.

How to use it: Active Risk tells you how far your portfolio behavior is drifting from the benchmark. Low active risk can mean you are closely tracking SPY; high active risk means you are taking larger benchmark-relative bets. It is not inherently good or bad — it becomes meaningful when paired with Alpha and Information Ratio to see whether the extra benchmark deviation is being rewarded.

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