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Wednesday, February 29, 2012.
Risk/Reward, Profit Factor and Profitability of Trading Strategies.
Let's say for example you are a currencies trader who has a mechanical system that wins 90% of the trades in back test. That's 9 winners out of 10 trades. Now, if that one loser is big enough, it can wipe out all the profits of the previous 9 winners, resulting in a flat account balance. That's the typical behavior found in scalpers. If the risk reward in your system is 9:1, that is your risk is typically 9 times bigger than your target profit, then winning 90% of your trades means you don't make any money after all. Thus, it is really important to talk about risk/reward when you mention winners percentage, otherwise talking about success rate is meaningless.
How can I determine if a system of a 9:1 risk reward ratio that wins 92% of the time is more profitable than a system with a 1:2 risk reward ratio that wins 50% of the time?
Wins 92% of the time. That is 92 trades out of 100.
Risk Reward ratio is 9:1 meaning if the typical winners is 1$ the typical loser will be $9.
Now, you do the math, 92 winning trades of 1$, that's $92 in positive territory.
Versus 8 losing trades of $9 dollars, that's $72 lost.
Finally you divide $92/$72 and that's a Profit factor of 1.28. Meaning, you make $1.28 for every dollar you lose.
Wins 50% of the time. That is 50 trades out of 100.
Risk Reward ratio is 1:2 meaning if the typical winners is 2$ the typical loser will be $1.
Now, you do the math, 50 winning trades of 2$, that's $100 in positive territory.
Versus 50 losing trades of $1 dollar, that's $50 lost.
Finally you divide $100/$50 and that's a Profit factor of 2.00. Your strategy makes $2 for every dollar it loses.
5 comments:
Well said, It gives me alot to think about.. I am just getting into forex and this one article has given me months more research to do! Thanks for the insight.
Tnx for very nice articles. Lets say that i have a sample of size N=1000. I calculate my ProfitFactor PF = 1.5 and I am pretty happy BUT there is a problem (of course). How do I convince myself that my sample size is not too small, and maybe my PF=1.5 is just some wrong value.
Hi, thanks for your comment. Well, I would say, if you get to test your strategy for the last 10 years, that is a significant period of time where presumably most market scenarios have been seen, from political crisis, wars, high volatility, low volatility, strong trends, lack of directionality etc. This is a tricky question to answer, I would suggest a sample size of 400 - 500 trades at least in those 10 years, but maybe yours is a daily system that issues less signals. For these cases some people consider that the minimum is 200 trades, that is the opinion of a well respected community over at asirikuy.
i appreciate highly of any lessons, sharing and standpoint in your blog..
you give a great help for many newbie traders.
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The information provided on this site is for education purposes only. The author is not a registered financial adviser and the ideas discussed on the site are just trading analysis and not recommendations. Lazy Trading LLC doesn't endorse any of the comments that might appear on the discussion threads. There is no guarantee for those comments to be accurate. By reading this site you automatically agree that The Lazy Trader (Lazy Trading LLC) is not responsible for any of your trading decisions. Remember not to risk money that you cannot afford to lose.
Calculating Profits And Losses Of Your Currency Trades.
Currency trading offers a challenging and profitable opportunity for well-educated investors. However, it is also a risky market, and traders must always remain alert to their trade positions. The success or failure of a trader is measured in terms of the profits and losses (P&L) on his or her trades. It is important for traders to have a clear understanding of their P&L, because it directly affects the margin balance they have in their trading account. If prices move against you, your margin balance reduces, and you will have less money available for trading.
Realized and Unrealized Profit and Loss.
Until a position is closed, the P&L will remain unrealized. The profit or loss is realized (realized P&L) when you close out a trade position. When you close a position, the profit or loss is realized. In case of a profit, the margin balance is increased, and in case of a loss, it is decreased.
The total margin balance in your account will always be equal to the sum of initial margin deposit, realized P&L and unrealized P&L. Since the unrealized P&L is marked to market, it keeps fluctuating, as the prices of your trades change constantly. Due to this, the margin balance also keeps changing constantly.
Calculating Profit and Loss.
Let's look at an example:
Assume that you have a 100,000 GBP/USD position currently trading at 1.6240. If the prices move from GBP/USD 1.6240 to 1.6255, then the prices have move up by 15 pips. For a 100,000 GBP/USD position, the 15 pips movement equates to USD 150 (100,000 x 15).
To determine if it's a profit or loss, we need to know whether we were long or short for each trade.
Long position: In case of a long position, if the prices move up, it will be a profit, and if the prices move down it will be a loss. In our earlier example, if the position is long GBP/USD, then it would be a USD 150 profit. Alternatively, if the prices had moved down from GBP/USD 1.6240 to 1.6220, then it will be a USD 200 loss (100,000 x -0.0020).
Short position: In case of a short position, if the prices move up, it will be a loss, and if the prices move down it will be a profit. In the same example, if we had a short GBP/USD position and the prices moved up by 15 pips, it would be a loss of USD 150. If the prices moved down by 20 pips, it would be a USD 200 profit.
The following table summarizes the calculation of P&L:
Another aspect of the P&L is the currency in which it is denominated. In our example the P&L was denominated in dollars. However, this may not always be the case.
In our example, the GBP/USD is quoted in terms of the number of USD per GBP. GBP is the base currency and USD is the quote currency. At a rate of GBP/USD 1.6240, it costs USD 1.6240 to buy one GBP. So, if the price fluctuates, it will be a change in the dollar value. For a standard lot, each pip will be worth USD 10, and the profit and loss will be in USD. As a general rule, the P&L will be denominated in the quote currency, so if it's not in USD, you will have to convert it into USD for margin calculations.
Consider you have a 100,000 short position on USD/CHF. In this case your P&L will be denominated in Swiss francs. The current rate is roughly 0.9129. For a standard lot, each pip will be worth CHF 10. If the price has moved down by 10 pips to 0.9119, it will be a profit of CHF 100. To convert this P&L into USD, you will have to divide the P&L by the USD/CHF rate, i. e., CHF 100 / 0.9119, which will be USD 109.6611.
Once we have the P&L values, these can easily be used to calculate the margin balance available in the trading account. Margin calculations are typically in USD.
You will not have to perform these calculations manually because all brokerage accounts automatically calculate the P&L for all your trades. However, it is important that you understand these calculations as you will have to calculate your P&L and margin requirements while structuring your trade even before you actually enter the trade. Depending on how much leverage your trading account offers, you can calculate the margin required to hold a position. For example, if your have a leverage of 100:1, you will require a margin of $1,000 to open a standard lot position of 100,000 USD/CHF.
Profit Factor and Trading.
If you want to improve your trading, you have to analyse your day's trading to identify flaws in your trading. To do this, there are a few statistical tools which enable you to evaluate the quality of your trades. One of the simplest and most effective tools is Profit Factor .
Definition of the Profit Factor.
Profit Factor is an index of trading skills . It evaluates with a figure therelation between risk taken and results.
If your trading results are good, your Profit Factor will be higher than 2 . Below this figure, you need to review your trading, even if you are making profits. In fact, a Profit Factor lower than 2 shows that the risks you take to increase your capital are too high. In the medium term, a trader with a Profit Factor lower than 2 is statistically doomed, the risks being too high to make a profit. This means that, at some point, losses will take the lead and that you will not have the ability to recover. With a Profit Factor greater than 2, your losses are covered.
How is Profit Factor calculated?
Profit Factor is calculated very simply : you add up all your winning trades and divide them by all your losing trades:
Profit Factor = (sum of earnings) / (sum of losses)
Profit Factor: practical example.
For example, on a trading day, all your winning trades come to €530, your total losses €280. At the end of the day, you have made €250 net and your Profit Factor is: 1.89 (530/280=1.89). So your day is positive, you are happy to have made a profit of €250. However the Profit Factor lower than 2 should warn you: you have taken too high a risk to make this amount, you tangibly lost €1 to earn €1.89. In the long term, your trading is too dangerous. Of course, for one day, that holds little value. You must assess Profit Factor weekly, monthly, quarterly, and annually. The longer the period the calculation is based on, the more relevant the result is and the more it qualitatively characterises your trading.
Profit Factor and risk management.
Profit Factor is therefore a powerful risk management tool that is often used by Hedge Funds to assess traders. The general philosophy of these Hedge Funds is high yield with minimum risk. We need to adopt this philosophy in our personal trading: so, it is better to make an average of €200 per day, with a Profit Factor of 3 (making an average of €300 for every €100 loss) than €400 per day with a Profit Factor of 2 (making €200 on average for every €100 loss).
My approach of Profit Factor.
This tool is often used by American Hedge Funds because it is relentless, you know immediately if the profits have been generated soundly and securely or unconsciously. In France, it is virtually unheard of, although it should be mandatory in deciding where to place money in the various funds. Yield is not everything, security of the placement is the first condition to be taken into consideration.
For my trading, I calculate my Profit Factor every week, every month, and every year as you can see in my stock market results. This enables me to assess my trading skills over time, to try to improve each day, week, month, year. Also, I prefer to make €500 a week with a Profit Factor of 7 than €1,500 with a Profit Factor of 3. If you want to evaluate traders' skills, ask for their annual Profit Factor. If they do not know what it is, they are not a trader but a clown.
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Profit calculator.
Before entering a trade, it makes sense that you would want to know what you stand to gain or lose from it. FXTM’s Profit Calculator is a simple tool that will help you determine a trade’s outcome and decide if it is favorable. You can also set different bid and ask prices and compare the results.
In 4 simple steps, the Profit Calculator will help you determine the potential profit/loss of a trade.
Pick the currency pair you wish to trade Choose if you are selling or buying Set the open and close price Select in which currency you would like to see the results.
Trade size (lots):
The real result of the order is subject to change due to various factors such as the release of news. Different account types employ different commissions and swaps and every position a different spread. The Profit Calculator does not take these values into consideration. Therefore, to get an accurate result, these values should be factored in manually. For additional information regarding swaps and commissions, please click here.
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