What is Profit Factor?
Profit factor is used to evaluate trading strategies and to measure their performance. It is simply a ratio of gross profits and gross losses.
In short, a trading strategy that earned $30 and lost $10 has a profit factor of 3. The profit factor should not be too low as there should be room for strategy deterioration, which is unavoidable.
Nowadays, market analysis programs allow traders to rapdily assess a trading system. This can be done by looking at theoretical results or real-time trading data, and there are many methods of measuring performance that can be used.
These performance measures are usually shown and discussed in a strategy evaluation process. This report is a collection of data on various aspects of the functionality of a trading system.
Knowledge of what information to assess in a strategy evaluation process can let traders evaluate a system for its pros and cons.
A strategy evaluation process can hold a huge amount of information about a trading system's performance. Out of these, there are five basic performance metrics with the most important ones being the Total Profit and the Profit Factor.
Trading Strategies, Profits, and Profit Factors
Most traders agree that an effective trading strategy can help make you a successful trader. It can be very difficult to earn money from the markets without one.
An investment strategy is what you will use to determine what assets you will invest in and how.
These strategies are based on YOUR rules and trading preferences, the amount of risk you are willing to take on, when you would like to get your capital back, and how much you are looking to increase it by.
In theory, your investment strategy determines which securities and investment avenues you will place your money. Many investors who have the means and can take risks invest in riskier investments because they are willing to gamble with their funds, as they have less responsibility and can survive the shock of losing some capital.
When developing trading strategies, traders generally use what is known as backtesting to see how their idea has done in the past.
Their strategy is applied to past data to see if it is a viable strategy or not. Doing this can let traders know what is worth trying in live markets and what is not.
A strategy is built on a few terms, and it’s up to the trader as the strategy developer to come up with concepts to apply to their strategy. This phase is the creative phase. It’s where they can hatch new ideas, and often the strangest trades go against the common trend and yield the best results.
Every strategy should first be tested on historical data to see how it pans out. However, this can be a frustrating phase as many trading ideas don’t perform that well in the testing.
As a matter of fact, the majority of the trade strategies tested end up being fairly useless in a test run.
Many traders simply use total net profit as a basic way to evaluate their trading performance. However, this metric can be misleading if used on its own as it cannot highlight if a trading strategy is working efficiently. And it also can't average out the performance of a trading strategy based on the level of risk that is taken.
It is certainly a useful metric, but total net profit is best when it is used together with other performance metrics like the profit factor.
Profit factor is the ratio of the gross profits divided by the gross losses. These are the values that the trading strategy earned and lost, respectively.
For example, a strategy with a profit factor of 4 should earn four times more than what it loses during the period. This means that a strategy that lost $100 would have to make $400, while a strategy that loses $40 would have to make $160 in gross profits.
The profit factor is one of the quickest and most efficient ways to see how effective a trading strategy is and can be a significant part of the personal strategy development process.
For instance, a trading strategy may yield a profit factor as low as 1. We can see immediately that this is probably not one which a trader would want to book trades. Such a strategy would probably quickly become a loss-making strategy at the smallest change in the market trend.
Trading for a very low margin or low profit factor is not advisable in trading.
In trading, the results can be different from the decision making process. A sound decision may result in poor results, and a bad decision can end up giving good results, but this is usually due to market variations and not because the decision making was poor.
This is true for single decisions or single trades, but multiple decisions need evaluation for their effectiveness
Reasons for a High Profit Factor
The need for a high profit factor depends on the trading strategy we are discussing.
The consensus is that a profit factor of 1 is profitable, over 2 is good and over 3 is outstanding.
So don’t be disappointed if it turns out that your profit factor is around 2 because that is also a great factor to have. It roughly means that for every loss making trade you book, there are two profitable trades for you.
The Opportunity Cost of Trading
Most trading strategies are designed to let the trader quickly change the number of trades made by changing the trading factors. However, once the trading conditions are changed and become less restricted, traders may also see their trading performance deteriorate.
For example, the profit factor and average trading returns may decline, and the strategy may also reduce the size of the trades.
However, the plan is still generating money because more trades are placed. This means that the trades added because of more lenient parameters which are still profitable, but just not as much as before.
A trader can find that the metrics improve as the number of trades reduces, the only one that will not improve this way will be the net profit. This is a tradeoff that traders have to adjust for while planning their trading strategies—the greed for profit and the need to have high quality trades to reduce loss potential.
In many cases, traders adjust their strategies according to market trends and pricing behavior.
Many others opt to go for algorithm based trading where a computer plans out strategies and trades them. This enables traders to apply multiple trade strategies through the computer algorithm, making it possible to tighten trade parameters and trade the best trades only. This should allow for higher profits and better quality trades, at least that is the theory.
Profit Factor is All About Risk
Let's say that you have finalized a strategy with an expected profit factor of 2 and it has produced 300 trades over the past decade using just two variables.
The trades can improve or deteriorate when you start changing the two variables. When the threshold is loosened to generate more trades, you can notice that the profit factor and the max drawdown deteriorates.
However, the strategy will earn more money on the whole because of the greater number of trades. This is a true reflection of the risk return trade-off between risk is taken and payoff. No risk, means no return.
This trade-off is what all traders face daily. Traders want to maximize profit as much as possible, but on want to get their profit with the lowest possible loss.
One solution to this problem is to try automatic or mechanical trading. This allows traders to trade multiple strategies that can get you stable returns.
It is preferable to hold a trading arsenal of tried and tested techniques. By combining strategies that individually only have a profit factor of 1.75, but when used together, the total of all the strategies can yield an improved profit factor because of their variety.
It is a good idea to be able to trade with as many independent strategies as possible in your locker.
Profit factor is a key metric for evaluating a strategy’s bottom line performance. As a rule, we are looking for profit factors of at least 1.5 or above to trade strategies successfully. This ensures that there is room for strategy deterioration over time which is natural.