What is the proper way to calculate volatility for the long short portfolio?
if calculated in a standard way the offsetting positions are driving it down.
How about Sharpe Ratio? that has an impact on the SR either
You calculate them the same way that you would for any other pnl stream. First calculate the excess returns, i.e. the P&L after accounting for financing (for a long-short portfolio, your financing includes the difference between the rates at which you can borrow and lend cash, as well as any fees for shorting particular instruments) divided by your risk capital.
Then the volatility is the standard deviation of your excess returns, multiplied by the appropriate annualizing factor.
Your Sharpe ratio is the average annualized return, divided by the annualized volatility.
You can either estimate volatility based on gross exposure or NAV. Usually you estimate it on gross and then use your leverage to estimate NAV volatility. Sharpe ratio is not impacted by leverage - returns and volatility should both be estimated on the same basis (NAV/gross) so they cancel out.