Trade your Equity Curve

System traders understand that their approach to trading requires nerves-of-steel patience while in a drawdown, gut-wrenching discipline in taking every signal generated by the system (and I mean every signal – no ifs, ands, buts or maybes) and cat-like reflexes in executing signaled trades before doubt can creep into the kernel regressing, quadratic equation. Whoever said that system trading takes the emotions out of trading doesn’t know the half of it. Doubters and skeptics of system trading recite the ‘past performance doesn’t guarantee blah, blah, blah’ mantra, refer to the perils of overfitting and data mining, and express a general independence from the enslaving nature of system trading. Well, you’ll be happy to know that you can be a system trader and not take every trade. How? Trade your equity curve.

Your system’s equity curve is how much money it’s making. Any standard package will be able to draw the simple chart for you. It has its ups and downs, with hopefully more ups for your sake. The goal for system traders is to create a smooth equity curve, meaning there are no radical departures from a gradually increasing trendline.

If your system’s equity curve looks sloppy and you can’t live with it, you either stop trading the ugly beast or you start a process of making it look better, which usually involves adding filters (to get the bad trades out) and other overfitting exercises. If you start down the path of overfitting so that everything looks neat and pretty, you might as well quit trading right now and donate your trading capital to a local charity. You’ll save yourself frustration and feel good about contributing to your community.

A natural tendency amongst system traders upon viewing an ugly equity curve is to revert to their discretionary trading habits. Take this trade, but not that one. It’s no longer system trading at that point, but discretionary trading with system tools. There is another way to maintain the integrity of the vast amounts of statistical data you acquired about your system during its development. And that is to code an algorithm to throttle or feed your system based on its equity curve performance.

I’ll offer three equity curves but instead of the naked one you’re used to viewing, I’ve added a MACD on a lower panel and two simple moving averages, a red one (50 day) and a green one (20 day).

The first one is a no-brainer. With an equity curve like this one, you want to keep trading it. Feed it, nurture it and read it bedtime stories.

It’s steadily climbing with the 20-day average nicely above the 50-day, and the MACD not showing any warning signs. If this is your equity curve, nice work.

Next, let’s look at one that may be in a little bit of trouble.

It has had a steep run-up just lately, but now the spread between the 20-day and 50-day is tightening to the point where the 20-day is threatening a breach of the 50-day. The MACD shows stalling momentum and a general decline.

Finally, let’s look at a not-so-pretty equity curve. This one has had its 20-day crossover its 50-day, and the MACD is confirming a deteriorating situation of steady decline and sub-zero line occupation.

Do yourself a favor, and let this system tell you what it’s going to do next before allocating anymore funds to it.

For system traders, it’s just a matter of programming when your system takes a trade or leaves a signal alone. You can program a moving average crossover or a host of other technical indicators that you may use in any typical trading system. You’re not being discretionary if you program under what equity curve conditions a trade is taken. The programming aspects involve creating a shadow or virtual system that follows along your regular system. I haven’t programmed one yet myself, but I know I can do it in TradersStudio. I’ll post the system once I’ve gotten it correctly coded.

Equity curves are not unlike stocks, and stocks are not unlike equity curves. That’s why we sometimes refer to stocks as equities. Your system is basically a stock that you’ve invested time and energy into. You can employ the buy-and-hold philosophy with your system, or you can trade it.

To emphasize the fact that you can view your equity curve just like you would any stock, ask yourself what favorite stocks the three equity curves above look very similar to. If you guessed AAPL, IBM and F, then you’re right.



6 Responses to “Trade your Equity Curve”

  1. Jez Liberty Says:

    I guess what you are saying is to trade a martingale or anti-martingale strategy. I am not sure I would always agree with that as you'll probably find that there is little serial correlation between your trade outcomes (in any case you'd probably want to measure that serial correlation). If you take Trend Following as a system, you would have a large winning trade "paying back" for many small losses – and you don't want to miss that trade! Whci you could do with trading your equity curve. I'd really recommend Raplh Vince on Money Management/Allocation for automated systems trading. He touches on that aspect of wheteher to trade equity curve + serial correlation of trade outputs. It is very good in general (some hail it as one reference in Money Management).

  2. Milk Trader Says:

    Yes, you could use either martingale or anti-martingale without that much programming wizardry. You can also place a system stop limit at a certain level, and 'scale into winners' if the system is steadily increasing its equity.

    I agree that there are problems with 'missing out' on the big winner because you're using a lagging indicator (basically every technical indicator).

    You can use your system's equity curve in a wide range of ways. As a money management tool, it may have some issues. As an indication that something has gone terribly wrong, maybe more useful.

  3. rara avis Says:

    Sorry for asking, but what is a "martingale" strategy? Is it a "St. Petersburg Paradox"-like strategy, or does the term refer to martingales in probability theory?

  4. Milk Trader Says:

    Martingale is a probability theory and is commonly used to refer to the gambler who always doubles his bet after losing. In a coin flipping game, he will eventually win. But he must have unlimited funds.

    If were to apply Martingale to trading an equity curve, you would double your contracts when the equity curve shows a decline. Not recommended by those whose aim it is to accumulate capital in their trading accounts.

  5. Woodshedder Says:

    Milk, for a system that trades often, try taking a rolling 20 trade average of the Win% plotted over the total average.

    Also look at the rolling 20 day average of the average trade plotted over the total average.

    Use that to trade the equity curve. TraderStudio is only software I know that will let you turn the system off and on while still tracking everything as if it were never turned off.

  6. fisherking61 Says:

    martingale strategies hardly strike one as the hallmark of prudent money management. If there is one single rule of thumb that has served me well over 20 years in the business, "never increase your losers" (whether expressed in terms of individual trades or as a % of equity curves) would be it. Leaving aside fancy math, if one still wanted to pursue martingale strategies (based on some kind of mean-reversion or other similar statistical reasoning), then a hard-and-fast monetary loss limit should be set in advance as a floor for one's equity curve. The lesson of the last 2 years is that increased macro risk has resulted in lower diversification across markets and instruments, the latter being categorised digitally as risk averse or risk seeking. Under these conditions, portfolio diversification assumptions (which underpins equity curve mechanics) have to become more prudent, since – as more than one market observer has aptly put it – "it all becomes one trade" (risk-averse or risk-seeking). Lower diversification means in turn that drawdowns and loss streaks increase (as if one had just one position on) and in turn require a higher equity risk capital allocation.

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