Trading System #1–Initial Assessment (Part 3)

In my last post http://www.optionfanatic.com/2012/09/20/trading-system-1-initial-assessment-part-2/ (9/20/12), I focused on the concept of drawdown (DD) in the current backtest.  Today I want to analyze Profit Factor (PF).

In my opinion, PF may be the most critical system statistic to study.  PF is defined as:

# winning trades                   average gain

————————-      x         ———————-

# losing trades                     average loss

Stated differently, PF is how many dollars are gained per dollar lost.

A profitable system will have a PF > 1.  If PF < 1 then the system loses money.  An outstanding system prospect will have a PF > 2.

PF should be studied in conjunction with exposure.  In many instances, PF and exposure are inversely proportional.  A system may have an outstanding PF but trade only once per month.  That will likely not give you sufficient profit to trade unless you trade the system really large.  This would be too risky with regard to the possibility of Ruin.

Table 1 (http://www.optionfanatic.com/2012/09/19/trading-system-1-initial-assessment-part-1/) shows that the average 5-day SPY trade generated a PF of 1.18 vs. 1.43 for all 5-day SPY trades commencing on a VIX close at least 5% above its 10-SMA.  This suggests the latter is a more profitable system, but as discussed in my last blog post, exposure is smaller.  As I also discussed, max DD is smaller, which may enable us to trade larger.  Column 3 shows the larger position size also generates the higher PF along with a higher net profit %.

I hope you are gaining an appreciation for the complexity of system development.  Many statistics must be analyzed together and in reference to each other.  Even when that is done, different conclusions can be made depending on what is most important to the individual trader.