Sortino Ratio

The Sortino ratio addresses a structural limitation of the Sharpe ratio: standard deviation treats upside and downside volatility symmetrically. For a strategy that occasionally produces large positive returns (e.g. trend-following EAs catching extended directional moves), the Sharpe ratio penalises this positive volatility, undervaluing the strategy.

Formal definition: Sortino = (R̄p − T) ÷ DD, where R̄p is mean return, T is a target return (often 0 for retail comparisons), and DD is the downside deviation — the root mean square of returns below T. Annualisation follows the same √period scaling as Sharpe.

Practical bands for annualised Sortino on retail forex EAs: below 1.0 indicates either poor edge or excessive downside risk; 1.0-1.5 is marginal; 1.5-2.5 is good; above 2.5 is excellent. Example: an EA with 20% annual return where the downside deviation is 8% has Sortino = 20/8 = 2.5.

When Sortino is preferred over Sharpe: strategies with naturally asymmetric return distributions — trend-followers, breakout systems, options-style strategies, and any system that targets large wins relative to small losses. When Sharpe is sufficient: strategies with roughly symmetric distributions like mean-reversion or grid (where the distribution is symmetric but skewed by hidden tail risk — Sharpe captures the apparent volatility but misses the tail entirely; both ratios underestimate grid risk).

Limitation: Sortino, like Sharpe, assumes ergodic and stationary returns. Real trading edges decay; high Sortino on a short backtest does not guarantee continued performance.