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Why the Profit Factor is the most revealing number on a trading account statement…

If you want to evaluate a trading approach or system within a split second, you need to look at the Profit Factor. The profit factor is the most important number/analytic on a trading statement because it immediately tells the quality of our trading approach.

Profit Factor is an index of trading skills. The relation between risk taken and results achieved expressed in a single number.  This number tells us with a high degree of probability if our current results are sustainable.

Traders tend to believe that their approach is good if their statement is showing a profit.  However, how do we know  if our results will last over time?  Well, if your profit factor is less than 1, within a year from now, you trading account will be marked with a tombstone…

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: 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,a Profit Factor lower than 2 should warn you: you have taken too high a risk to make this amount, you effectively lost $1 to earn $1.89. In the long term, your trading is too dangerous. Now, for only one day, there is not enough data to make an assessment.  We should 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 accurately describes the quality of your trading.

Profit Factor and Risk Management

The Profit Factor is  a powerful risk management tool that is used by Hedge Funds to assess their traders. The approach of these Hedge Funds is to generate a high return with minimum risk. We would be wise to adapt their approach 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 to Profit Factor

This tool is often used by  Hedge Funds because it is relentless, you know immediately if the profits have been generated soundly and securely or unconsciously.  Yield is not everything. preservation of initial capital should be the first priority.

I look at my Profit Factor every week, every month, and every year. This enables me to assess my trading skills over time, to try to improve each day, week, month, year.  For example, I prefer to make $500 a week with a Profit Factor of 7 than $1,500 with a Profit Factor of 3.


Maximum Drawdown

To improve your trading, you must be able to analyze the quality of your trading. The Profit Factor coupled with the Maximum Drawdown will give you an “honest” statistical view of the quality of your trading.

Definition of Maximum Drawdown

Maximum Drawdown means the historic maximum loss in the trading account. This is one of the numbers used by institutional funds to grade traders. If a trader makes money but has a max drawdown of -20% for example, he/she will be fired…

How to calculate the Max Drawdown

It is very simple, you must identify your maximum loss in a day, a week, a month, or a year … I calculate my max drawdown daily, then recalculate it for the week, month etc.

The Maximum Drawdown and risk management

The maximum Drawdown is therefore a little mean. It does not spare you. You can make 50 winning trades, but it waits for you around the corner. If you go on with bad trades, they can accumulate … and the Maximum Drawdown continues to increase without the possibility of ever dropping. Even if you could then trade like a god, the Maximum Drawdown will always be there to tell you: “yes this is my guy, but you have made a historic loss of € xxx or x%, you can always show off.” It is an indelible mark…

My view of the Max Drawdown

So, the Maximum Drawdown is a calculation to determine the quality of a trader or trading system and is an addition to the PROFIT FACTOR in determining the quality of a trader or a trading approach.

Thus, we see a statement that shows a 50% return but, if it has a max drawdown of -30%, and you enter at the wrong location, you can also lose -30%.

Conversely, an investment at +25% with a max drawdown of -2% is much more interesting, you are risking -2% maximum to win +25% maximum.

After all is said and done, a trader must determine what is most important to him/her.  Preservation of capital or the highest possible return.  There is a direct correlation between risk and return.  The higher the risk the higher the return.  At some point we must answer the question to ourselves because it has a tremendous effect on how we should look at our trading approach/system…