Profit Factor is a trading performance indicator defined as the ratio of gross profits to gross losses. A Profit Factor greater than 1.0 denotes a profitable system; a factor of 2.0 or more is good, while a factor above 3.0 is considered outstanding. It is advisable to use the Profit Factor with other metrics to offer a holistic picture.
What is a Profit Factor?
Market analysis platforms these days allow traders to review trading systems quickly. You can also create strategy performance reports to assess your actual trading results through these. In a process known as backtesting, you can also apply trading rules to the historical data to determine the system’s performance during the specified period.
Meaningful performance metrics are not mere statistics; they also have a lot many essential functions:
- Dictate and guide the development of trading strategy
- Monitor trading outcomes against intended benchmarks
- Diagnose potential problems
We cannot conclude that the strategy is acceptable based only on the return as it doesn’t consider the volatility of returns or maximum drawdown. Therefore, it is essential to quantify processes to evaluate their performance, and the profit factor is the most widely used strategy.
The profit factor is the gross profit ratio to the gross loss (including commissions) spanning across the entire trading period. This performance metric helps us understand the amount of gain realized per unit of risk. A profit factor greater than one indicates a profitable, non-risk-adjusted system.
ProfitFactor = (GrossWinningTrades/GrossLosingTrades)
Profit Factor is also an effective risk management tool used by Hedge Funds to evaluate traders. Besides simplicity in its calculation, the significant advantage of the profit factor is that this ratio tells us how much we earn for each dollar that we lose. For example, if you get a Profit Factor of 1.5. If you invest $1, you can expect to earn $1.5.
We are working on a new trading strategy with four entry signals this week. 2 winners are $500 and $300, and 2 losers are $200 and $150, including slippage and transaction fees.
When we apply the profit factor formula, we get:
This means that the winning trades are 2.28 times higher than the losing trades. It also indicates that for every $1 invested in this strategy, we will be able to earn $2.28. The profit factor suggests that ours is a profitable strategy. However, I do want to add that just four trades are not enough to assess the performance of a trading system.
Now let’s take another example:
Now let’s say this time we have three winning trades and two losing trades, five trades. The winners are $250, $150, and $200, while the losers are $300 and $500. Applying the formula, we arrive at a Profit factor of:
($250+$150+$200) / ($300+$500)= 0.75.
Thus, we could say that our winners are lesser than losers or that for every $1 that we invested, we realize only $0.84. This trading strategy needs improvement.
There are a few variants to the Profit Factor formula that we can use to compare various scenarios. One such depiction is:
ProfitFactorAltenative} = (WinRate * AverageWin) / (LossRate * AverageLoss) $%
- Average win is calculated by taking all winning trades and dividing them by the number of winning trades. It is the expected value of an average winning trade.
- Average loss: This is calculated by taking the sum of all losing trades and dividing it by the number of losing trades. It is the expected value of an average losing trade.
Let’s understand this with an example with five entry signals in a week. There is 1 winner (5000) and 4 losers (1500+ $1000+500+200). Thus, the profit factor is:
$5000/ ($1500+$1000+$500+$200) = 1.56
The result shows that the system is profitable, but the metric fails to show a low Win rate and a high Drawdown rate. It’s going to be challenging to sustain multiple losses in a row, and that one trade alone cannot vouch for the entire trading system to be profitable.
This video by Ninja Mastery explains the concept lucidly:
What is a Good Profit Factor?
Any ratio greater than one means we can earn more than we lose. So, technically:
- A factor higher than 1 denotes a winning system.
- A factor lower than 1 denotes a losing system.
However, trading strategies with a profit factor of just over 1 are not worth trading. This is because you would like to trade these trading strategies first since even a tiny change in the market can render the trading strategy fruitless. This is because a low-Profit factor denotes a small margin which isn’t ideally acceptable in trading. Additionally, we’re discussing returns that are not risk-adjusted — meaning if we’re barely profitable, we should invest in a safe, guaranteed return vehicle such as at-bills instead of assuming risk.
As a trader, we would always want to select a strategy with a high margin of safety. Anything in the range of 1.25 and 1.75 indicates a minimal safety margin.
Also, you will need to bear particular out-of-pocket expenses like trading platform fees, broker commissions, bank commissions, market data expenses, taxes, etc. These expenses are an integral part of the trading business, which you need to pay from your trading profits.
I don’t trade any system below a 2.00 profit factor unless it’s a hedge.
The Gain-to-Pain ratio (GtPR ) is a close cousin of the Profit Factor. The only difference between GtPR and profit factor calculation is that the Gain-to-pain ratio has the net profit of all the monthly or weekly trades divided by the absolute value of the net trading loss for the period.
Simply put, the Gain-to-Pain ratio depicts the amount of pain required to acquire some level of gain. Just like the Profit Factor, the GtPR will always be positive.
GtPR should ideally be maintained for three- and five-year periods, though a one-year data is also a strong performance indicator. A GtPR above 1.0 is good, and above 2.0 is excellent.
The Profit Factor doesn’t tell us anything about the distribution of the trades in the trading system. A profit factor greater than one does not necessarily imply that the trader is consistent. A positive factor could result from a single winning trade, even if the remaining trades have resulted in losses.
Thus, even as the profit factor helps assess the trading system’s performance, it is essential to see the holistic picture and view the result against a few more pertinent points. Some of these points are:
- The number of transactions that the trading system had
- If the maximum drawdown is more than the trader’s risk threshold
- The amount of dispersion in a result that the trading system shows
- The ratio of winning trades
- The average profit per trade
The trader needs to list the significant ratios to evaluate a trading system to get a balanced view. It isn’t a wise move to see the profit factor in isolation. The various metrics complement each other, and they collectively help us see the bigger picture and arrive at a better analysis.
The profit factor is a mathematical ratio obtained by dividing the gross profits by the gross losses. The values between 1.75 and 4 are the most acceptable ones. However, we are skeptical about values below and over this range. A low-profit factor indicates a weaker trading strategy, while a ratio of more than 4.0 may seem too aspirational in real life.
One solution to these dispersions and fluctuations in real life is automated or algorithmic trading. This allows you to opt for many strategies that can smoothen your returns.
This would be possible if you had a portfolio of quantified strategies. Using several methods, you could earn a higher profit factor due to its diversity.
To aim for a higher Profit factor, you need to participate in different markets across diverse time frames. A blend of strategies and automated trading will only boost its possibility.