Profit Factor - What it is and how it is calculated
When evaluating trading strategies, we are aided by many different types of measures of a strategy's performance. One of the most common is the profit factor.
Profit factor is simply the ratio between gross profit and gross losses. This means that a strategy that lost $200 but gained $400 will have a profit factor of two. In trading, it is essential to ensure that you have a profit factor that is not too low, in order to leave room for strategy degradation, which is inevitable.
In this guide, we will take a closer look at using the profit factor as a way to inspect the performance of a trading strategy.
You will also learn what a good profit factor is and how it can vary by strategy type.
What is the Profit Factor
As we just explained, the profit factor is the ratio between gross profit and gross losses. For those who don't know, gross losses and gross profits refer to the total amount a strategy lost and gained, respectively.
For example, for a strategy to have a profit factor of 3, it must make three times as much money as it lost during the period. This means that a strategy that loses $100 would have to yield $300, while a strategy that loses $50 would have to produce $150 in gross profit.
In fact, the profit factor is one of the best ways to evaluate the performance of a strategy and is an important part of our own strategy creation process. It can often give a good indication about the robustness of the strategy.
For instance, from time to time you may come across trading strategies that have a profit factor of only 1.1. Generally, these are not trading strategies that yield from trading in the first place, as the slightest change in the market behavior would threaten to make the strategy unprofitable.
The margin is very small, which is never ideal when it comes to investments.
What is an acceptable Profit Factor?
There is actually no definitive answer to this, but if you ask us, we would say that we are not prepared to trade strategies with a profit factor lower than something around 1.2. Once you get past 1.2 the margins start to get higher and the strategy has a better chance of working in the future.
However, we'd rather get to something around 1.4-2 to feel totally comfortable.
Again, these limits are our personal opinions and may vary depending on who you ask!
What is a High Profit Factor?
So knowing that we like to see a profit factor of at least 1.25, but you may wonder what we consider to be a high profit factor.
Well, it varies depending on the trading style. For instance, having a profit factor of 3 or even more is not extremely high when we are talking about mean-reversion strategies, but it is certainly a lot for other types of trading strategies.
However, if we had to provide a general rule of thumb that applies to all types of strategies, it would be that a profit factor of 3 or a bit more, is high, although still realistic. Profit factor 3 is what we look for when we design our Forex Signals Forex Copy Trade strategies.
Still, anything from 2 up is great and should be considered high!
Now that you know what Profit factor is, take a look at our previous results report where you can find in detail the results of our High Frequency Trading (HFT) strategy Automated Forex Signals system.
Stay tuned to the results reports, released on a weekly and/or monthly basis.