What is Profit Factor
How to compute it with examples from real backtesting
One of the main concerns related to the usage of trading systems is optimization. Good backtesters know how to optimize trading strategies. Once you have had a trading idea, you have to set some variables and write down the algorithm for your trading platform. I noticed that usually what happens during backtesting does not happen in real time. What a trader usually does after backtesting is taking the results and trying to optimise the system by adjusting the variables. Despite what people think, optimising a system can be negative for it.
Overoptimization can lead to infallible models on historical data, but inconsistents on the field.
This is due by the spread between historical evolution and future development of the market. So it is useless to program fitting algorithm for just one scenario trying to overoptimize them, it could be more useful to use trading systems with little parameters and not optimized ones, instead of a complex system, good just for the past and not for the present. In order to evaluate if your trading system is strong enough, take it and run it over other futures, stocks, commodies and whatever you want. If you have a profit, it is another strong evidence about the robustness of your trading idea. Of course it could be a trading system fitting just one or two stocks, in this case it is not important that it performs well over other markets, but still remains the need of not overoptimising the system.
Now we come to the main topic. We are going to analyze one of the most important indicator for backtesters: Profit Factor. It is a simple but fundamental indicator.
Here I present a report from MT4
Profit Factor for this report is 2.50, but what really is profit factor? It is the ratio between Gross profits 895.57$ and Gross loss 357.86$ in this model.
Profit Factor = 897.57 / 357.86 = 2.508159615492091879505952048287
Basically Profit Factor means that if I invest 1 dollar I can expect to get 2.5$ back from trading that model. So I can expect to take back my dollar and earn a profit of 1.5$ per contract. So a profit factor equal 1 means that if you invest 1 dollar, you get back exactly the dollar you invested (not that good deal) while taking the risk of losing it. A profit factor higher than 1.5 means that you get half the investment corrisponding value in profit, so for each dollar invested you earn 50 cents.