Profit factor
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, p. 198).
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, p. 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, p. 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, p. 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, p. 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, p. 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, p. 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.
Examples of Profit factor
- Trading system: A trading system might have a profit factor of 2.0, meaning that it earned two dollars for every dollar lost.
- Portfolio: An investor’s portfolio might have a profit factor of 3.2, meaning that it earned three dollars and twenty cents for every dollar lost.
- Mutual Funds: A mutual fund might have a profit factor of 1.5, meaning that it earned one dollar and fifty cents for every dollar lost.
- Hedge Funds: A hedge fund might have a profit factor of 4.5, meaning that it earned four dollars and fifty cents for every dollar lost.
- Commodity Futures: A commodity futures trader might have a profit factor of 2.7, meaning that it earned two dollars and seventy cents for every dollar lost.
Advantages of Profit factor
The profit factor is an important tool for assessing the performance of a trading strategy as it allows for the comparison of the potential returns to the potential risks. The advantages of this metric include:
- It provides a single number that summarizes the overall performance of the strategy - the higher the number, the better the performance of the strategy.
- It takes into account both the positive and negative trades of a strategy, thus providing a more comprehensive measure of risk-adjusted returns.
- It allows traders to compare different strategies and identify which one is more profitable and which one has a lower risk-reward ratio.
- It helps traders identify strategies that are suitable for their risk profile and investment goals.
- It can also be used to evaluate the performance of a trading system over time and identify trends in performance.
Limitations of Profit factor
The profit factor is a useful tool for measuring risk-adjusted profitability of a trading strategy, but it has several limitations:
- It does not consider the magnitude of the profits and losses. In other words, it does not take into account the amount of money gained or lost on a particular trade.
- It does not factor in the duration of trades. It only looks at the profits and losses of the same strategy at a given point in time.
- It does not take into account the amount of capital that is used to generate the profits and losses.
- It is not capable of distinguishing between trading strategies that are successful over the long-term and those that are successful over the short-term.
- It does not measure the consistency of a trading strategy; it only measures its profitability.
In addition to the Profit factor, there are several other methods for measuring the risk-adjusted profitability of a trading strategy. These include:
- The Sharpe Ratio, which measures the excess return of the strategy over the risk-free rate, divided by the risk of the strategy.
- The Sortino Ratio, which is similar to the Sharpe Ratio, but takes into account only the downside risk of the strategy.
- The Calmar Ratio, which measures the average annual return of a strategy, divided by its maximum drawdown.
- The Sterling Ratio, which measures the average annual return of a strategy, divided by the average annual volatility.
In conclusion, the Profit factor is just one of the many ways to measure risk-adjusted profitability, and there are many other approaches that can be used to gain insight into a trading strategy.
Profit factor — recommended articles |
Calmar Ratio — Net yield — Market value ratios — Running yield — Yield on cost — Economic value of equity — Simple rate of return — Combined Ratio — Free cash flow yield |
References
- Dormeier B. (2011), Investing with Volume Analysis: Identify, Follow, and Profit from Trends, FT Press
- Gildersleeve R. (1999), Winning Business: How to Use Financial Analysis and Benchmarks to Outscore Your Competition, Gulf Professional Publishing
- Katz H. C., Meltz N. M. (1991), Profit Sharing and Auto Workers' Earning: The United States vs Canada, "Relations industrielles", Vol. 46, No. 3
- Lim M. A. (2015), The Handbook of Technical Analysis + Test Bank: The Practitioner's Comprehensive Guide to Technical Analysis, John Wiley & Sons
- Long R. J. (1997), Motives for Profit Sharing: A Study of Canadian Chief ExecutiveOfficers, "Relations industrielles", Vol. 52, No. 4
- Murphy J. J. (2009), The Visual Investor: How to Spot Market Trends, John Wiley & Sons
- Nguyen T. N. M., Tran P. T. (2015), Factors Affecting Personal Financial Management Behaviors: Evidence from Vietnam, "Proceedings of the Second Asia-Pacific Conference on Global Business, Economics, Finance and Social Sciences"
- Pruitt G., Hill J. R. (2003), Building Winning Trading Systems with TradeStation, John Wiley & Sons
Author: Patryk Kozioł