One of the most important tasks that you must perform as a trader is the statistical analysis of your trading strategies. This analysis leads to an evaluation objective of the results, but above all an understanding and interpretation of what these results are telling us.
Mathematical statistics have allowed us to develop mathematical analysis tools, such as indicators or metrics, with some calculations simpler and more intuitive than others, which allow us to analyze the results of our trading systems.
In this case I am going to talk to you about the Profit Factorone of the most important metrics and that the vast majority of beginner traders ignore at the beginning because we focus only on profits (see the Lambos and champagne bottles on Instagram).
1. What is the Profit Factor or Benefit Factor?
The Profit factor is a measure that shows the relationship or ratio between the total of the earned money and the total of lost money by the system or trading strategy that we are evaluating.
The formula to calculate the Profit factor is quite simple:
Profit Factor = Gross Profit / Gross Loss
Or in other words in a simpler way:
Profit Factor = Sum Profit Winning Trades / Sum Lost Losing Trades
Now let’s see with a simple example how to calculate this indicator.
2. How to calculate the Profit factor?
Suppose our trading strategy shows us the following results:
|Operation No.||Gain / Loss $|
To calculate the Profit factor, the first thing we must do is add up all winnings in our winning operations and in the same way add up all the losses from our losing trades. Then we calculate according to the formula indicated above.
Gross Profit = 39+48+61+24+43+31 = 246
Gross Loss = -37-49-36-27 = -149
Profit Factor = 246 / 149 = 1.65
In this simple way we can calculate such an important metric. But now that we have learned to calculate it, a question arises: What does this obtained value tell us? Is good or bad?
3. Interpretation of the Profit Factor.
If we analyze the formula used to calculate the profit factor we can deduce the following:
- If the result obtained is equal to 1means that the gross profit is equal to the gross loss and our system does not generate us neither profit nor loss.
- If the result obtained is greater than 1, it means that the gross profit is greater than the gross loss and our trading strategy is profitable.
- If the result obtained is less than 1, it means that the gross profit is less than the gross loss and our trading system is not profitable.
The profit factor tells us the amount of euros or dollars (depending on the base currency of our account or trading system) that we earn for every euro or dollar that we lose. In our previous example, the value 1.65 tells us which trading system is winning or profitable, and for every dollar we lose, we earn $1.65.
You can check the profit factor on platforms like fxblue or myfxbook by connecting your trading account as you can see in the image above. Also and previously on the platform where you build or execute your strategies.
Now, is this result a good or acceptable result? A profit factor of 1.65 is definitely considered a good or acceptable value. If we base ourselves on the definition of the indicator, it is clear that the higher the value of the profit factor the better and more profitable is our trading strategy, however, this is not easy to achieve.
If we evaluate a system with few trades, it is possible to obtain a profit factor equal to 2 or even 3. However, as we increase the number of trades, this value can be around 1.5 at best. Ideally, our trading system should have a minimum profit factor of 1.5 or 1.6.
4. Advantages and Disadvantages of the Profit Factor.
An advantage from the mathematical point of view is the simplicity of your calculation. On the other hand, the profit factor does not depend on the simulation period or the volume of the base lot.
Another fundamental advantage of this metric is the ease of interpretation of its numerical value: This value tells us how many dollars we earn for every dollar we lose.
The main disadvantage of the profit factor is that the value of this metric largely depends on the number of operations of our trading system. In fact, this metric does not provide us with any information regarding the distribution or evolution of our operations. For example: Suppose we have 9 losing trades that add up to a total of $100 in losses and we have a winning trade of $200, the profit factor in this case is equal to 2, however we could not affirm that this is a profitable trading system. since that winning operation could be a matter of chance.
Although this metric allows us to quickly and easily evaluate the performance of our trading system, we must rely on other metrics to have a overview of our systemfor example: the capital yield curve or balance line of the system, number of operations, percentage of operations won, R squared, among others.
5. How to use the Profit Factor in your trading
In my case I use it as a star measure in my trading systems and in particular I find it very good for connecting or disconnecting systems. For example, if a trading system goes on a losing streak, its profit factor drops considerably and we can use it to disconnect the system. In the same way you can apply it to connect a real system. Remember that systems are not forever…
Finally, I recommend that you never use the profit factor as the only metric or indicator to evaluate and determine if your trading strategy is profitable or not. The ideal is to complement the information provided by this indicator with other ratios.
Did you know this indicator? How do you use it? Tell you in comments!