Profit factor

Profit factor
See also

Profit factor is one of the ways to look at risk-adjusted profitability. The profit factor takes into account how much money we can gain for every dollar we lost within the same strategy. The most important feature of this factor is measuring risk by comparing the upside to the downside. The profit factor is defined as the gross profit divided by the gross loss (B. Dormeier 2011, s. 198).

\(Profit Factor=\frac{Gross Profit}{Gross Loss}\)

Buff Dormeier in his literary work entitled "Investing with Volume Analysis: Identify, Follow, and Profit from Trends" present this example: "For instance, one issue might generate $40,000 in losses and $50,000 in gross gains, whereas a second issue might generate $10,000 in losses and $20,000 in gross gains. Both issues generate a $10,000 net profit. However, an investor can expect to make $1,25 for every dollar lost in the first system but $2 for every dollar lost in the second system. The figures of $1,25 and $2 represent the profit factor" (B. Dormeier 2011, s.198).

Gross Profit

Gross profit is the profit a company makes after deducting all direct costs from net sales revenue. Gross profit will appear on a company's income statement and might be counted by subtracting the cost of goods sold from revenue. These statistics can be found on a company's income statement (R. Gildersleeve 1999, s. 5).

Gross Loss

Gross loss is the amount of money the company has paid of spending such as payroll, equipment purchases, duty fees, and leasing charges. The amount calculated is the balancing figure to be put on the credit side as a part of balancing the account (M. A. Lim 2015, s. 920-925).

Difference between Profit Factor and other statistics

Both the most important difference and the biggest advantage of profit factor that separate it from other statistics is the possibility to use profit factor to compare other markets. Other statistics, like total profit and a maximum drawdown cannot be precisely compared with the same statistics from distinct markets. The profit factor is normalized between various markets. When we calculate a trading strategy performance across a broad spectrum of markets, we would skip the total profit as the only guiding factor for portfolio selection. Thereupon, profit factor seems to be the best statistic to compare one market equally against another (G. Pruitt, J. R. Hill 2003, s.92).

John J. Murphy describing the problem of using visual tools at the broad spectrum of markets in this way: "The preceding chapters provided you with the necessary tools to perform visual analysis of the financial markets. That material deliberately avoided an exhaustive description of available market indicators to stress those that are the most useful. This focus also provided you with selected visual tools that can be used across a broad spectrum of markets and asset classes. With so many investment choices available to today's investor, both on a domestic and a global scale a relatively simple system is needed in the search for superior performance" (J. J. Murphy 2009, s. 47)

Adjusted Profit Factor

George Pruitt and John R. Hill in their work of literature describing adjusted profit factor in this way: "The adjusted profit factor is an even better performance statistic. Adjusted profit factor is calculated by dividing adjusted gross profit by adjusted gross loss. Adjusted gross profit/loss is calculated by subtracting/adding the square root of winning/losing trades from the total number of winning/losing trades and multiplying the result by the average winning/losing trade, that is, deflating profit and inflating loss" (G. Pruitt, J. R. Hill 2003, s.92). In simple words adjusted profit factor displays the amount made about the amount lost, for a worst-case scenario during the specified period. By definition, a value bigger than 1 means the strategy has a positive adjusted total net profit.

\(Adjusted Profit Factor=\frac{Adjusted Gross Profit}{Adjusted Gross Loss}\)

References

Author: Patryk Kozioł