Profit factor is a simple yet powerful metric that calculates the amount of profit generated per unit of risk. It is calculated by dividing the total profits achieved by the total losses incurred.
Profit factor helps measure how effectively your portfolio generates profits and can help you assess your portfolio's performance. By understanding profit factor and how to calculate it, you can make more informed decisions about your investments.
How to calculate profit factor
To calculate your portfolio’s profit factor, add the profits from your winning trades and the losses from your losing trades, then divide the total profits by the total losses.
For example, assume you have a ten trade sample with seven winners ($150, $350, $400, $200, $200, $250, $450) and three losers (-$250, -$400, -$350). The seven wins have generated $2,000 in profits and the three losing trades have -$1,000 in losses. Your total net profit would be $1,000 with a profit factor of 2.0 ($2,000 / $1,000).
A profit factor higher than 1 means your system is profitable overall. In this example, a profit factor of 2 indicates that your winners are twice as high as your losers on average. Essentially, every one dollar invested equals two dollars earned.
What affects profit factor
There are a few things that can affect the profit factor. One of the most important variables is the relationship between your win rate and profit factor.
A win-rate above 50% means you win on more trades than you lose. But a high win-rate may not be enough if your losses are significantly larger than your wins. If your portfolio generates large profits but also incurs large losses, the profit factor will be lower than if your portfolio generates small profits and losses.
For example, a 65% win-rate strategy where the average winning trade makes $70, and the average losing trade loses $160 is a losing strategy overall. So, it is essential to consider how your win rate and the size of your wins and losses balance each other.
In the ten trade example above, the win rate is 70% (7 wins, 3 losses). However, a trading system could just as easily have a profit factor over 1 with a small win rate if the winning trades are consistently much larger than the losing trades.
Commissions, taxes, and other trading fees associated with investing can impact your portfolio’s overall performance, so it is important to track these metrics along with gross profits and losses.
It is critical that you understand your trading system’s expected performance and factor in how your win rate and profit factor mesh with your emotional reactions. Some traders will struggle if they only win three out of every ten trades, even if their profit factor is greater than one. While other traders may mistake a high win rate with a profitable trading system.
How to use profit factor to improve your portfolio returns
Now that you understand profit factor, how to calculate it, and how it relates to win rate, here’s a few tips on how you can use it to improve your portfolio's performance.
Using profit factor to compare different portfolios
If you're trying to decide between two different portfolios, the profit factor can be a helpful metric. Simply calculate the profit factor for each portfolio and compare the results. The portfolio with the higher profit factor is likely to be more profitable over the long-term. Remember, a large sample size is key to determining portfolio performance.
Using profit factor to assess your risk-reward ratio
Profit factor can also be used to assess your portfolio's risk-reward ratio. To do this, simply compare the profit factor to the Sharpe Ratio. The Sharpe Ratio measures risk-adjusted returns, while profit factor measures actual returns.
If the profit factor is higher than the Sharpe ratio, it means that your portfolio is generating more profits than would be expected given the level of risk. This could indicate that your portfolio is taking on too much risk or that you're not being compensated enough for the risks you're taking.