Profit Factor and Trading
If you want to improve your trading, you have to analyse your day's trading to identify flaws in your trading. To do this, there are a few statistical tools which enable you to evaluate the quality of your trades. One of the simplest and most effective tools is Profit Factor.
Definition of the Profit Factor
Profit Factor is an index of trading skills. It evaluates with a figure therelation between risk taken and results.
If your trading results are good, your Profit Factor will be higher than 2. Below this figure, you need to review your trading, even if you are making profits. In fact, a Profit Factor lower than 2 shows that the risks you take to increase your capital are too high. In the medium term, a trader with a Profit Factor lower than 2 is statistically doomed, the risks being too high to make a profit. This means that, at some point, losses will take the lead and that you will not have the ability to recover. With a Profit Factor greater than 2, your losses are covered.
How is Profit Factor calculated?
Profit Factor is calculated very simply: you add up all your winning trades and divide them by all your losing trades:
Profit Factor = (sum of earnings) / (sum of losses)
Profit Factor: practical example
For example, on a trading day, all your winning trades come to €530, your total losses €280. At the end of the day, you have made €250 net and your Profit Factor is: 1.89 (530/280=1.89). So your day is positive, you are happy to have made a profit of €250. However the Profit Factor lower than 2 should warn you: you have taken too high a risk to make this amount, you tangibly lost €1 to earn €1.89. In the long term, your trading is too dangerous. Of course, for one day, that holds little value. You must assess Profit Factor weekly, monthly, quarterly, and annually. The longer the period the calculation is based on, the more relevant the result is and the more it qualitatively characterises your trading.
Profit Factor and risk management
Profit Factor is therefore a powerful risk management tool that is often used by Hedge Funds to assess traders. The general philosophy of these Hedge Funds is high yield with minimum risk. We need to adopt this philosophy in our personal trading: so, it is better to make an average of €200 per day, with a Profit Factor of 3 (making an average of €300 for every €100 loss) than €400 per day with a Profit Factor of 2 (making €200 on average for every €100 loss)!!!
My approach of Profit Factor
This tool is often used by American Hedge Funds because it is relentless, you know immediately if the profits have been generated soundly and securely or unconsciously. In France, it is virtually unheard of, although it should be mandatory in deciding where to place money in the various funds. Yield is not everything, security of the placement is the first condition to be taken into consideration.
For my trading, I calculate my Profit Factor every week, every month, and every year as you can see in my stock market results. This enables me to assess my trading skills over time, to try to improve each day, week, month, year. Also, I prefer to make €500 a week with a Profit Factor of 7 than €1,500 with a Profit Factor of 3. If you want to evaluate traders' skills, ask for their annual Profit Factor. If they do not know what it is, they are not a trader but a clown.
Next article: Maximum DrawDown