The profit factor of a trading strategy depends on the two components trade ratio and payoff ratio. The trade ratio is the ratio of profitable to loss-making trades, the payoff ratio is defined as the quotient of the average profit from profitable trades and the average loss on loss-making positions. If you understand the relationships between these performance indicators, you can start developing your own system.
From the fact that profit factor = payoff ratio * trade ratio applies, several very valuable insights can be derived. One of them is that only the average loss per trade can be directly influenced by the trader himself. The loss can be limited by setting a stop loss at the opening of each position. Against the background of the equation above, it becomes clear why loss limitation is so important for success in trading. Those who do without it give up an important tool without need.
Understand the profit factor: Success knows more than one way
Another key finding is that trading systems can be successful in different ways. Theoretically, the profit factor can be greater than one (then profits are made) if either the payoff ratio or the trade ratio takes a very small value above zero. A prerequisite is a correspondingly large value for the other key figure.
This in turn means that a system can be highly profitable, even if the majority of it produces losses. This is the case if the losses are justifiable through effective loss limitation and at the same time the profits achieved are sufficiently large. In practice, a narrow loss cap leads to a worse trade ratio because deficit positions are closed out with a (small) loss. The loss limitation also reduces the average loss and thus has a positive effect on the payoff ratio.
Beginners who are interested in finished trading systems should also consider the psychological component in trading. Experience has shown that trading systems are very difficult to keep up if they produce a long series of losses and only generate their profits through comparatively few large profits. Systems of the “collector type” that lead to success with many small profits are simpler.
Profit factor, payoff ratio and trade ratio alone are not sufficient to assess the quality and validity of a trading system. Further examinations are essential for reasons of caution. A simple example: If a very high proportion of the overall profit was achieved with very few trades, the risk of chance hits without any real meaningfulness is high. In addition, the performance of the trading system should be assessed across several overarching trend phases.