Introduction to Profit Factor
Posted by Mark on April 24, 2012 at 10:51 | Last modified: April 24, 2012 10:52The profit factor (PF) is one of the most important statistics to calculate when developing a trading system.
PF is defined as total profits divided by total losses. Another way of stating this is:
average net profit on winning trades # winning trades
——————————————————- * ————————– (1.1)
average net loss on losing trades # losing trades
Although very similar, I would point out that PF is not exactly the same as a trading system’s expectancy (E):
Expectancy (E) = (Probability of Win * Average Profit) – (Probability of Loss * Average Loss)
E may be interpreted as the average gain or loss per dollar risked on a trade. PF may be interpreted as the number of dollars made per dollar lost. A successful trading system should have E > 0 and PF > 1.
Maintaining a relative equivalence between average losses and average gains is one way to run a successful income trading business. Consider a trading strategy that sells 20 naked puts per month for $2.00 each to collect $4,000. These puts are so far out of the money that only a very rare event will result in a loss. Eventually, October 2008 happens and this very consistent trade suddenly loses $396,000. Not only did this one month just wipe out profits from your last 99, but the psychological devastation will likely result in a swift career change.
The PF calculation gives us the minimal requirements by which to profit through income trading. If a strategy’s average losses are three times its average gains then the second term of (1.1) must equal at least 3 for PF to exceed 1. That is, three trades must win per every trade lost: a win rate of 75%. Similarly, if the strategy loses twice as much as it usually gains then it must win 67% of the time to break even.
I will build on this concept of PF in my next post with an introduction to Sizing Risk.
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[…] my last post on profit factor (http://www.optionfanatic.com/2012/04/24/introduction-to-profit-factor/), I mentioned that one way to run a viable trading business it to keep the average loss somewhat […]