Myths and facts of equity curve trading

March 16, 2015 12:00 PM

Most traders have heard the concept of turning a trading strategy on and off — or increasing/decreasing size — when the equity curve rises above or falls below a specified moving average, breaks to a certain new low (or high), or has a specified number of consecutive losing days. The fact is every trader does some sort of equity curve trading, whether they realize it or not. Once a trader makes a decision based on the equity curve, he is in effect equity curve trading.

One specific and popular method of equity curve trading involves the use of an indicator as an overriding switch. A moving average switch on the equity curve is the most popular method. The premise is to trade only when the equity curve is above its moving average. Of course, proponents of this equity curve trading technique typically show glowing examples that “prove” the usefulness of the technique. But, does it really work? How do you set it up and evaluate it? 

This two-part series will examine the pros and cons of equity curve trading. In this first part, we’ll establish definitions and some baselines for the analysis. In the second installment, we’ll examine equity curve trading for some real-life trading systems.

Trading the curve

In its simplest form, equity curve trading is a methodology in which the strategy is turned on and off based on the characteristics of the equity curve. This typically is done by applying an indicator (such as a moving average or a breakout to the equity curve), or by employing a trigger as the switch (for example, the trigger could be turning off the strategy after X days of consecutive losses). 

An example of equity curve trading is shown in “Above average” (below). In this case, the strategy is turned off when the “always on” equity curve dips below its 25-period moving average. When the “always on” equity is above the moving average curve, the strategy is allowed to take trades. Consequently, trading is allowed for the trades in blue, and trading ceases (that is, the trader is net flat) for the red trades.

Note that after following the above rules, there is one blue trade taken below the equity curve and one red trade taken above it. This is not an error and actually highlights an important mistake many people make. The blue trade below the moving average is taken because the equity curve does not drop below the moving average line until after the trade is completed. Before that trade (that is, after the previous trade), the equity curve is above the moving average, which indicates that the next trade should be taken. When using an equity curve switch, you need to be careful to make sure that trade decisions are made only with prior knowledge.

“Reaping rewards” (below) shows the net effect of this particular equity curve trading, with a comparison to the original curve. As seen in the chart, in this case the performance improves because of the equity curve technique.

Of course, using a moving average calculation on an equity curve has all the disadvantages that a traditional moving average has on market price data: It has a built-in lag by definition. Its performance also suffers in whipsaw-type situations, and the moving average can be over-optimized on historical data. Because of this, it may be useful to look at other types of equity curve triggers.

One trigger could be an n-bar breakout. In this application, the system would stop trading when an n-bar low of the equity curve occurred. Trading would cease until the original equity curve turned back above the n-bar low. This indicator, though, also could be over-optimized by varying the value of n until a good “fit” was discovered.

Another possible trigger is to turn off the strategy after so many days or trades of consecutive losses. From a psychological point of view, such an approach might have appeal for many traders. It would not work in cases where consecutive losing days tend to be followed by winning days (a reversion-to-the-mean situation), which in fact does occur with many trading systems.

Equity curve trading can get very complicated, because just about any indicator or trigger could be applied to it. In effect, it becomes its own trading strategy, but instead of buy/sell decisions being made on the instrument price data, the decisions are made on the equity curve.

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About the Author

Kevin J. Davey has been trading for more than 25 years. Kevin is the author of “Building Winning Algorithmic Trading Systems.”