The same goes for the message-posting guy. He probably has a bunch of trad-
ing systems with back-tested profit factors around four, none of which come any-
where close to showing the same profitability in real life—chances are he’s even
losing money. The solution, he believes, is to crank up the back-tested profit factor to
around seven and hope that he will land somewhere around three or four in real life.
Two related objections against that type of reasoning need to be raised here.
Number one is the robustness of a profit factor as high as seven, or even three.
Number two is the absurdity of it in the first place. Let’s start with the absurdity,
which also will help us understand why such a high profit factor is more likely to
ruin you than anything else.
Building a good and robust trading system is not a question of maximizing
the profit factor, but simply making it as reliable as possible and just high enough
to warrant trading at all. It should be high enough so that the return on the amount
risked is higher than what you could have made elsewhere, plus an appropriate
premium for assuming that risk. Think about it as any normal fairly long-term
business endeavor. What is the most you expect to make on the amount risked
when opening up a coffee shop, a dental practice, a small factory producing plas-
tic thingies, on investing (not trading) in the stock market? Probably not more than
25 percent a year, and the stock market has an average long-term return of around
12 percent. Then what makes you think you can make so much more trading? Do
you have any idea what type of returns on the amount risked that a profit factor of
two, three, or seven represents? If not, I will tell you.Calculating Risk
To calculate the profit factor, simply divide the gross profit by the gross loss. The
answer will tell you how many dollars you are likely to win for every dollar you
lose. For example, say that you have $2 and decide to take part in a game where
you have a 50 percent chance to win and, every time you do so, you win twice the
amount you risked. The first time you try, you risk $1. You lose, and your gross
loss is therefore $1. With your last dollar, you take another chance and this time
you win $2, ending up with a total of $3, and your gross profit is therefore $2. Two
divided by one equals two, which is your profit factor.
Now assume that the game changes so that you only have a 33 percent chance
to win, but when you win, you win three times the amount you risked. This time,
you start out with two losing bets, and your gross loss, therefore, is $2. With your
last dollar, you win $3 and end up with $4. In this case, the profit factor comes out
to 1.5 (3 / 2). (If you look at all five trades, you lost three trades for a total of $3
and won two trades for a total of $5, for a total profit factor of 1.67 [5 / 3].)
The profit factor tells you how much money you made in relation to how
much money you lost. How much money you lost and how much money you actu-
ally risked is not the same thing. The amount risked is equal to the total amount48 PART 1 How to Evaluate a System