Profit Factor

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Profit Factor-Important or not?

After the article on risk to reward ratios I thought I should touch a little on profit factor.

Profit factor is simply the the profit generated by profitable trades divided by the losses generated by losing trades. The greater the number the better or ‘less risk’ your trading system has.

Take an example of a system that has a $10,000 of profitable trades and $5000 of losing trades. The profit factor would be 2. This is the number that seems that internet traders quote a lot. It seems that if you have a profit factor of 2 then it is a good system to trade. This system would have produced a profit of $5000.

All sounds great eh? Well yes and know. Profit is king. However, profit factor doesn’t show the whole picture. It doesn’t show how many trades it took to make the $10k profit and how many it took to make the $5k loss. For all we know the system made 100 profitable trades and 5 losing ones.

This would mean and average of $100 per win and and average loss of $1000 per loss. a risk to reward ratio of 1:10!!! This is just rediculous. But this is how forex robots and expert advisors are sold and marketed

They claim to have great profit factors of 8 or more!!! But the reality is behind that number is a horror story waiting to happen.

In order to have these high profit factors the system but either have a a great risk to reward ratio or a great strike rate. You will find that these EAs etc have the latter. They have 95% strike rates (as in my $10/$5k example) but you can see it would only take a increase in less than 5 trades as losses i.e a 5% drop in winners to turn the system from a winner into breakeven. Or put it another way, if you daytrade every day…10 extra loses out of the whole year and that is your year wasted.

You are playing with fire if you trade like that. Naturally, some traders will say well you can’t expect a positive risk to reward ratio, such systems/methods do not exist. I would then suggest if you can’t find them then don’t trade. I don’t. I only trade when I think I have a good chance of making money. The numbers behind the method have to make sense. Profit factor is however only one number, don’t forget strike rates and risk to reward ratios to create a better picture of your trading system.

2 Responses

  1. Alex says:

    Good recap of this concept and I agree, anything north of 3 for Profit Factor should be under suscpicion for over-fitting. This comes straight from Pardo’s book (Design, Testing, and Optimization of Trading Systems).

  2. GreatTradingSystems says:

    Haven’t read that book to be honest. Anygood?

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