In general terms, mechanical trading systems are derived from statistical observations that forecast a market’s upcoming likelihood to trend or trade sideways. Considering the cyclical nature of markets and the fluctuating volatility of market prices, systems’ returns naturally ebb and flow over time as market conditions shift.
Usually at high volatility levels, trending systems perform well and sideways systems tend to fail. Likewise, during periods of low volatility, trading-range systems perform whereas trending systems lag. Therefore, regardless of the nature of the system, the equity curve will experience drawdown periods.
Traders, of course, are always in search of techniques to reduce drawdowns and even turn losing periods into winning ones. There are several ways to measure volatility in an attempt to forecast this, but one of the most practical simply is monitoring the performance of the system itself. Analyzing the equity curve is a straightforward way to predict how a particular system will perform. Here, we will show how equity curve analysis can improve mechanical trading system results by not only identifying changes from congestion periods to trending ones, but also allowing the trader to capitalize on this shift.
Trading the equity curve
One simple way to gauge the cyclical effect of markets on trading systems is to apply percentage-based drawdown stops to the system’s performance. Percentage-based equity stops do not refer to a percentage drop in the underlying market, they refer to a percentage drop in the system’s equity, from the highest measured point of the equity curve to the present. (Both kinds of stops can be used simultaneously.)
Because the equity level is dynamic, it must be monitored either manually or by a programmed algorithm. This approach is a money management method that can be applied to any system, flattening the equity line.
Another useful technique involves performing trend analysis of the equity curve itself. Moving averages can be applied to the equity curve of a trading system to determine when and how to take trades from that trading system.
The calculation begins with a basic technical trading strategy. Such a system is one that currently does not employ any money management techniques. Such systems may be nothing more than a single indicator. This basic system will provide the equity curve that will be analyzed. The moving average will be calculated based on the equity curve of the basic system. The equity curve will be defined as “good” when it is above its moving average and “poor” when it is below it.
With this information, we can take several approaches to trade our system:
- Allow signals when the equity is above the moving average, and block trades when below.
- Allow larger trades when the equity is above the moving average, and smaller trades when below.
- Administer positions by filtering with different moving averages.
- Allow signals when the equity is above the moving average, but trade opposite to the system’s signals when the equity curve is below.