What is the profit factor in trading? Have you heard this term before and wondered what it means?
Read on to find out.
Trading is never easy. On the stock market, the lines between success and failure are very thin.
To be successful, some of the top minds formulate strategies and tweak them to get the best possible results.
This includes the creation of an idea and a thesis.
Research is then required to test the strategy to see if it has any practical value.
Finally, the strategy must be tested in a live market environment.
Formulating any type of strategy is just the beginning, and back tests follow to improve it.
Without this rating, investors have no idea whether they are the casino or the player at the blackjack table.
One such performance barometer is the profit factor.
This helps identify the profitability of a strategy.
A profit factor is the parameter used to evaluate the effectiveness of any trading strategy and can be calculated mathematically using the following formula:
Let’s take an example and calculate the profit factor of a strategy that results in three winning trades ($ 400, $ 800 & $ 300) and three losing trades (- $ 250, – $ 300 & – $ 200) for two weeks.
Shown in the graphic below.
The strategy win factor is = ($ 400 + $ 800 + $ 300) / ($ 250 + $ 300 + $ 200) which is 2.
A profit factor of 2 means that the winning trades are twice the size of the losing trades.
In other words, for every $ 1 of risk, the expected return is $ 2.
Usually, the higher the profit factor, the better the strategy performance. Nevertheless, there is no generally recognized success factor.
Usually a Win Factor greater than 1 indicates a winning system and less than 1 indicates a losing system. Even so, the profit factor is based on gross profit.
Transaction fees such as brokerage commissions, slippage and taxes are not taken into account.
This can mean that a Profit Factor slightly above 1 may not be profitable.
These should be taken into account when evaluating the performance of a strategy.
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In addition, any type of strategy will result in a drawdown phase and deteriorate in the future as the nature of the markets does not stay the same.
Therefore, the margin for strategy deterioration should be taken into account.
Just because something worked in the past doesn’t guarantee that it will work in the future.
Most likely, a strategy that performs very well over a period of time (e.g. momentum trading) will be a setback in the long run.
- It monitors and evaluates the performance of a trading strategy.
- It helps in adjusting the trading parameters of a strategy. Tightening the parameters helps to take only the good trades, which in turn can significantly increase gross profit and profit factor.
- It performs in eliminating strategies that have a bad profit factor.
- It helps in assessing the win rate and drawdown of a strategy.
Profit Factor is the single most important metric used to assess strategy performance, but using it alone to assess strategy is short-sighted.
Let’s take an example to analyze the problem related to the use of profit factor.
Suppose the first results of a new strategy lead to 4 losing trades (- $ 250, – $ 150, – $ 200, – $ 150) and two winning trades ($ 850 & $ 750) in two weeks, as shown in the graph below.
The profit factor in such a scenario would be = ($ 850 + $ 750) / ($ 250 + $ 150 + $ 200 + $ 150) which is 2.13.
It’s worth noting that the new strategy results in a significant Win Factor of 2.13, but there are a few points that need to be addressed.
- There are only six trades in the data set, so the profit factor cannot be reliable without a larger sample size.
- The drawdown appears to be high as there is a series of four consecutive losing trades.
The high drawdown and low win rate can burn a trader mentally even if his strategy has been profitable.
Furthermore, in a situation with a few big winners and frequent losers, it will take a significant number of events to find the true winning factor of a strategy.
For example, if we simply removed Trade 5 from this example, the Profit Factor is now negative.
The profit factor is a useful measure to evaluate the profitability of a trading system.
Even so, it has its drawbacks, as it doesn’t take into account the length of drawdowns and can oversimplify small samples.
It is best used in combination with other performance metrics to properly assess and evaluate the feasibility of any trading strategy.
Disclaimer: The information above is for For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.