Last Updated on 25 November, 2022 by Samuelsson
When evaluating trading strategies we are helped by many different types of measures of a strategy’s performance. One of the most common ones is profit factor.
The profit factor simply is the ratio between gross profits and gross losses. This means that a strategy that lost $200 but won $400 will have a profit factor of two. In trading, it’s essential to ensure that you have a profit factor that isn’t too low, in order to leave room for strategy degradation, which is inevitable.
In this guide, we’ll have a closer look at using the profit factor as a way of inspecting the performance of a trading strategy. You’ll also learn what a good profit factor is, and how it may vary by strategy type.
What is Profit Factor?
As we just explained, the profit factor is the ratio between gross profits and gross losses. For those who don’t know, gross losses and gross profits refer to the total amount that a strategy has lost and won respectively.
For instance, for a strategy to have a profit factor of 3, it must make three times more money than it lost during the period. This means that a strategy that loses $100 would have to make $300 dollars, while a strategy that loses $50 dollars would have to produce $150 in gross profits.
The profit factor indeed is one of the best ways to evaluate the performance of a strategy and is an important part of our own strategy creation process. Many times it can give a good indication about the robustness of strategy.
For example, once in a while you may stumble upon trading strategies that have a profit factor of as little as 1.1. Generally, those are not trading strategies you would like to trade in the first place since the slightest change in the behavior of the market will threaten to make the strategy unprofitable. You simply have a very small margin, which never is ideal in trading.
What Is an Acceptable Profit Factor?
There really is no definitive answer to this, but if you were to ask us, we would say that we’re not prepared to trade strategies with a profit factor lower than somewhere around 1.2. Once you get above 1.2, your margins are starting to get higher, and the strategy has a higher chance of working going forward.
However, we’d prefer to get up to somewhere around 1.4-2 to feel fully 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, you may wonder what we consider to be a high profit factor.
Well, it varies by trading style. For instance, having a profit factor of 3 or even more isn’t extremely high when we’re talking about mean reversion strategies, but certainly is a lot for other types of trading strategies.
However, if we were to provide a general rule of thumb that applies across all strategy types, it would be that a profit factor of three or slightly more is high, while still being realistic. A not too small percentage of our trading strategies have a profit factor that’s this high.
Still, everything from 2 and upwards is great, and should be regarded as quite high!
The Effect of Opportunity
When discussing what a good profit factor is, we cannot skip the discussion of opportunity.
Many trading strategies are built in a way so that you may adjust the number of trades quite freely by adjusting the parameters. However, as you loosen the conditions and become less restrictive about the trades you take, you will also notice how the performance metrics worsen.
For instance, the profit factor and average trade may go down, and the strategy may also produce greater drawdowns. However, due to the increase in the number of trades, it’s still making more money. That is, those trades that get added as you loosen the parameters are still profitable, albeit not as profitable.
Now, if you’re not happy with the performance metrics of the strategy with regards to profit factor, average trade, and so on, you may decide to tighten the criteria a bit. As the number of trades goes down, you’ll most likely find that most performance metrics improve, except for the net profit.
This is the type of trade-off you’ll have to do as a trading strategy designer. On the one hand, you want as much profit as possible. On the other hand, you also want your trades to be of as high quality as possible.
In our case, the solution to this issue is algorithmic trading. By letting a computer trade our strategies for us, we can trade as many as 100 strategies at a time, which makes it possible to tighten the criteria for each strategy to only take the best trades. At the same time, we get enough opportunity to make a substantial profit!
Profit factor is one of the best metrics when it comes to evaluating a strategy’s performance. In general, we wish to see values higher than 1.2 in order to trade a strategy, to ensure that there is enough room to accommodate strategy degradation, which is a natural part of trading.
However, while a high profit factor means that the trades taken are more profitable, tightening the criteria will also result in less profit as opportunity decreases.