As a professional, or aspiring trader something that you'll quickly learn is one of the most essential metrics to track is your profit factor. Profit factor is simply the relationship between profit and loss, and it provides you with a clear picture of your strategies performance. 

Before we dive deep into profit factor, it’s useful to know that anything below a profit factor of 1.0 (i.e. 0.9, 0.8, and so on) is a losing system, and anything with a profit factor above 1.0 (i.e. 1.2, 2.0, 3.4) will make money. Lastly, a profit factor of 1.0 = a break-even strategy.

Today, I’m going to cover what profit factor is, how to calculate it, and how you can maximize it to improve your edge and make more money trading.

What Is Profit Factor in Trading?

As a beginner, it all starts with the fundamentals, and this means that we’ll need to what profit factor is in the first place. Note that when calculating profit factor it’s important you get a good sample size of trades (similar to how you would when calculating strike rate) so we have enough data to work with.

Defining Profit Factor

Profit factor is the ratio of profits to losses in trading, or more specifically, the ratio of gross profits to gross losses. It's an indication of how much profit you earn for every dollar you lose. This indicates exactly how profitable your trading strategy is.

The formula for calculating profit factor is actually very simple: (Gross Profits / Gross Losses).

For an easy example, if a trader has gross profits of $12,000 and gross losses of $5000, the profit factor would be 2.4. In other words, for every dollar lost, $2.40 is made.

Why Profit Factor Is Such An Important Metric

Your profit factor is important to keep track of because it’s a good proxy for tracking the overall performance of your strategy. 

Unlike many other metrics that other traders may use, profit factor combines both losing and winning trades into one figure, therefore providing you with a concise and comprehensive overview of your overall profitability at a glance. 

The stronger profit factor is, the more likely your trading strategy is to be sustainable over a prolonged period of time, especially if you have a large sample size of trades to back it up. The higher the better, but remember if your profit factor dips below 1.00, your strategy is losing money.

How to Calculate Profit Factor

Now let’s go over how to calculate profit factor. Most automated trade journals will actually do this for you, but again it’s as simple as taking your gross profits and dividing it by your gross losses.

Example Profit Factor Calculation

• Add up your profits over a given period of time. For instance, if you have winning 8 trades, each of which provided you with $2,700 in profits, your gross profit would be $21,600.

• Next, you need to add up your losing trades. If you have losing 7 trades, each of which lost $1000, your gross losses would be $7,000.

• All you have to do now is plug those figures into the formula, by dividing $21,600 (gross profits) by $7000 (gross losses), resulting in a profit factor of 3.08.

Interpreting the Results

Being able to interpret your results is just as important as being able to make the calculation. But again it’s super simple, because all you need to remember is that if your profit factor is above 1.0, your system is profitable, and if your profit factor is below 1.0, you’re losing money. 

Generally speaking, a profit factor between 1.5 and 2.0+ is considered ideal, but a higher profit factor is totally viable if you’re able to catch a healthy average winning trade with a good strike rate to match.

Improving Your Profit Factor

The higher your profit factor is, the more money you end up banking at the end of each day, so let's talk about some ways that we can improve upon it.

Ensuring Your Strategy Has Edge

This one almost goes without saying, but not every strategy has an edge. There are a lot of trading strategies out there that are too discretionary, have overly complicated rules that negate what little edge they may have, or simply don’t have a real edge.

Conversely, there are also some very good strategies out that have a great edge backed up by traders who are actively trading it and have a track record to match.

Adjusting Your Trading Frequency 

To increase your profit factor, cut out low probability and low profitability trades. It’s important to remember that as a trader, less is often more. Hitting every single trade (including ones that are outside of the scope of what your strategy considers a valid trade setup) is an easy way to erode your profitability. 

Every trade you take exposes you to risk, so we need to be clear about our criteria for what makes a good trade setup, and we need to be confident as well as competent in our edge to enter valid trade setups without hesitating.

Common Mistakes That Will Negatively Affect Profit Factor

There are a couple of common mistakes that negatively impact profit factor, including over-trading, poor risk management, and ignoring consistent losses.

Overtrading and Poor Risk Management

If you enter too many trades, you're likely going to decrease your overall profitability. The more trades you enter, the more risk you take, the higher chance of decision fatigue, and the more opportunities for you to make trading errors/mistakes, or to make impulsive decisions.

At the same time, poor risk management can also cause unexpected losses that negatively impact your overall profit factor. If you find yourself touching your stop loss after entering a trade and taking bigger losses than normal, it’s time to cut that bad habit out.

Ignoring Consistent Losses

Many traders focus on profits alone while ignoring mounting losses. While you might be tempted to celebrate your wins and ignore your losing trades, but this is how traders fall into the trap of repeating the same mistakes over and over. Analyzing your past wins and losses to see where your trading strategy worked (or didn’t) using a trade journal/tracker is crucial for long term profitability.

In Conclusion

That pretty well sums everything up you need to know about profit factor, and how to improve it (and make more money as a trader).

That’s it for today my friends!
-Brian