The Profit Factor and Trading

27 9 2014 - No comment

If you want to improve your trading, you must analyse your trading day to identify flaws in your trading. To do this, there are some statistical instruments you can use to assess the quality of your trades. One of the simplest and most effective instruments is the Profit Factor.

Definition of the Profit Factor

The Profit Factor is a quality index of trading. It assesses as a figure the relationship between the risk taken and the results.

If your trading is good, your profit factor will be greater than 2. Below this figure, your trading needs to be reviewed, even if you generated a profit. In effect, a Profit Factor less than 2 indicates that the risks taken to increase your capital are too high. In the medium term, a trader with a profit factor less than 2 is statistically damned, as the risks are too high to generate a profit. This therefore means that losses will at some point take over and you will not have the opportunity to recover. With a profit factor greater than 2, you are safe from extinction.

How to Calculate the Profit Factor ?

It is easy to calculate the Profit Factor: you add up all your winning trades and divide them by all your losing trades:

Profit Factor = (sum of profits) / (sum of losses)

The Profit Factor: concrete example

For example, on a trading day, all your winning trades are € 530, and all your losses are € 280. In the end, you won €250 net and your profit factor is:  1.89 (530/280 =1.89). Your day is therefore positive, you are happy to have made a PV of €250 but the profit factor less than 2 should be a cause for alarm: you took too much risk to earn this money; you actually lost €1 to earn €1.89. Your trading would become too dangerous in the long term. Of course, this is not significant in the course of one day; you have to assess your profit factor per week, month, quarter, year. The longer the period on which the calculation is based, the more the result is pertinent and qualitatively describes your trading.

The Profit Factor and risk management

The Profit Factor is therefore a powerful risk management tool which is widely used by Hedge Funds to evaluate traders. Having a high return with minimal risk is the general philosophy of these Hedges Funds. It’s up to us to adopt this philosophy for your personal trading: thus, it is better to earn on average €200 per day with a Profit Factor of 3 (on average when you lose €100 you win €300) than €400 per day with a profit factor of 2 (on average when you lose €100 you win € 200)!!!

My vision of the Profit Factor

This instrument is widely used by U.S. hedge funds because it is implacable. you immediately know if earnings were generated sensibly, safely, or unconsciously. In France it is virtually unknown, it should however be mandatory for one to decide where to invest his money in the various funds. The return is not everything; the security of the investment is the first criterion to take into account.

For my trading, I calculate my profit factor weekly, monthly and yearly, as you can see in my results in the stock market. This allows me to assess the quality of my trading in time, and try to improve my performance daily, weekly, monthly, and yearly. So I prefer to earn €500 a week with a profit factor of 7 than € 1,500 with a profit factor of 3. If you want to evaluate the quality of a trader, ask him his annual Profit Factor. If he does not know what it is, he is not a trader but a joker.

Next Article: The Maximum DrawDown



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