What Profit Factor Measures When Comparing Trading Systems
Summary
The document distinguishes profit factor from absolute return when comparing trading systems. Profit factor is defined as total winning amounts divided by total losing amounts, so it expresses gains relative to losses. It does not account for position size or leverage, and therefore does not by itself show which strategy made more money in the example period.
The examples contrast a system with a lower profit factor but higher stated return against one with a higher profit factor and lower return. The answer interprets the higher ratio as indicating more gains per unit of loss and potentially a smaller proportional drawdown. This is a limited comparison: the examples use only two trades each, and profit factor alone does not establish overall strategy quality, risk, or future performance. Position sizing, leverage, and other measures are needed to make a broader comparison.
Key ideas
- Profit factor is total winning amounts divided by total losing amounts.
- A higher profit factor does not necessarily mean higher absolute returns.
- The metric omits position sizing and leverage.
- Profit factor compares gains with losses and may indicate proportional drawdown characteristics.
- Compare systems using other measures as well as profit factor.
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# Why "profit factor" is used to compare trading strategies?
# Why "profit factor" is used to compare trading strategies?
A lot of books/articles/trading forums mention that "profit factor" is probably the most important measure and should be used to compare different trading strategies. They define profit factor as total gains/total loss. I can understand having a profit factor > 1 means the trading system is making money but I think you can't use this number for comparing trading strategies. Trading system with higher profit factor doesn't necessarily make more money than one with lower profit factor. For example if we have two trading strategies A and B as below,
Trading strategy A: Has a profit factor of 2
Trade 1: Buy XYZ @ 100 on Monday and sell it @ 150 on Tuesday making a profit of $50.
Trade 2: Buy ABC @ 100 on Wednesday and sell it @ 75 on Thursday for a loss of $25
Profit factor = $\frac{\\\$50}{\\\$25} = 2$
Rate of return for this strategy = $25\%$
Trading strategy B: Has a profit factor of 3
Trade 1: Buy XYZ @ 100 on Monday and sell it @ 109 on Tuesday making a profit of $9.
Trade 2: Buy ABC @ 100 on Wednesday and sell it @ 97 on Thursday for a loss of $3
Profit factor = $\frac{\\\$9}{\\\$3} = 3$
Rate of return for this strategy = 6%
Isn't the trading strategy "A" better than "B"? What am I missing here?
## Answer by jeanlouie (score 1)
https://quant.stackexchange.com/a/60145
When it comes to trading systems, and not investment strategies, profit factor is a great metric to use. Sharpe Ratio is for comparing returns as an excess over a risk free option per unit volatility, but when it comes to trading, the risk free option like bonds or a low risk market index isn't really an option.
To be clear, $pf = \frac{\%win rate \times avg win} {\%loss rate \times avg loss} = \frac{total wins}{total losses}$. That division sign makes the metric a ratio, comparing the wins to the losses, or comparing returns to per unit loss. Note that this excludes all issues of position sizing and leveraging.
In your example, strategy A: pf = 2, ror = 25%, strategy B: pf = 3, ror = 6%. Based on the ror, A performs better, based on the pf, B performs better. What's the difference? The pf tells you that for A, it made 2x as much as it lost (+50/-25), but for B, it made 3x as much as it lost (+9/-3), the equity graphs for A and B would be very diferent. In other words, the drawdown in profit/performance/equity for A was 50% (-25/+50), but for B it was 33% (-3/+9). All B has to do do is to increase position size or use leverage to exceed the raw $ returns of B, and it'll do so with less volatility in it's balance.
TDLR:
- pf compares wins per unit loss
- pf excludes position sizing in describing the profitability of a trading system
- a higher pf may indicate a smoother equity graph with less proportional drawdownShown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.