The profit factor is an important requirement to track the efficacy of your trading strategy. It indicates the ratio between the total gross profit and total gross loss.
It is a simple technique that tells you if your trading strategy is good or not.
Say you are trading without knowing how much you are gaining and losing. You will eventually start losing tons of money because trading forex is not an easy task. You need to know whether the strategy you are using is even working or not.
How to calculate the profit factor?
The simple way to read this method is if the ratio is more than one, then you are in a net profit. Let’s discuss the example if you have made 1000$ of profit in a session, and if in the same session you bear a loss of 850$, then the profit factor is 1.18.
To put it in simple words, for every 1.18$ you earn, you lose 1$. The net profit you gain is .18, which is 18 percent of the earnings
Another example of this could be that you earn 850$, but in the process, you lose 1000$. In this way, your profit factor will be 0.85. For every .85$ you earned, you also lost 1 dollar.
If your profit margin is more than 2 means, you are trading very successfully. A profit factor of 2 means that you are earning twice more as you are losing. And if by chance it is more than 3 that means you have hit the jackpot.
Limitations of Profit factor
One of the major drawbacks of the profit factor is that it only tells us about the net profit. Having a profit factor of more than 1 does not necessarily mean that the strategy is working because it masks the win-loss ratio of trades.
For example, if you win a trade successfully and earn about 3000$, but in the next couple of trades, you keep losing 300$, 500$, 1000$ and 100$. The Sum of all the losses is 1900$, which is still less than that one big win. So, it might give you a false sense of achievement, while your strategy might be flawed.
Continuing the previous example, this also highlights another shortcoming of this strategy. It might show you that you are losing, but it does not highlight the flaws in your trades. You might need to be more vigilant to get a better grip on trading.
Profit factor might be a well-thought way to calculate your net profits and losses to keep a general track of your trading. But, because of some major flaws, it cannot be relied on heavily.
You can use this method as a simple tool to help you better understand your trading sessions and try new strategies, whether they are even working or not.