What Is Profit Factor In Trading?

Introduction

Trading is never simple. In the stock market the margins between success and failure are razor thin.

To succeed some of the top minds formulate strategies and streamline those to achieve the best possible results.

This involves the creation of an idea and thesis.

Then research is needed to back test the strategy to see if it has any practical value.

Finally, the strategy needs to be tested in a live market environment.

Formulation of any kind of strategy is just the beginning and the same is followed with back testing to improve it.

Without this evaluation investors have no idea whether they are the casino or the gambler at the blackjack table.

One such barometer of performance is the Profit Factor.

Which helps to identify the profitability of a strategy.

What is Profit Factor?

A profit factor is the parameter to evaluate the efficacy of any trading strategy and can be mathematically calculated using the formula as:

profit factor trading

Let us take an example and calculate the profit factor of a strategy which results in three winning trades ($400, $800 & $300) and three losing trades (-$250, -$300 & -$200) for two weeks.

Shown in the chart below.

The profit factor of the strategy is = ($400 + $800 + $300)/ ($250 + $300+ $200) which comes to be 2.

A profit factor of 2 states that the winning trades are twice as large as losing trades.

In other words, it can also be said that for every $1 in risk, the return expected is $2.

profit factor formula

What Is The Accepted Profit Factor Level?

Normally, the higher the profit factor, the better is the performance of the strategy. Despite this there is no universal profit factor that is recognized as successful.

Normally, a profit factor greater than 1 indicates a winning system and less than 1 a losing system. Despite this, the profit factor is based on gross profits.

As this is the case transaction fees such as broker commissions, slippage and taxes are not considered.

This can mean that a profit factor slightly over 1 may not be profitable.

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