Equity curve analysis: A fool’s path?

April 15, 2015 12:00 PM

Results

Results for the gold  strategy are shown in “Gold: Equity analysis” (below). As mentioned in the first installment, although net profit and maximum drawdown are important numbers, the ratio of the two (net profit/maximum drawdown) is of primary concern. A higher ratio is preferred because it tells us that we are receiving more profit for each dollar of drawdown.

As seen in the table, equity curve trading for the gold strategy is almost always worse when compared to the “always on” approach. An example of the different equity curves for the moving average technique is shown in “Feedback effect” (below). 

In this case, it is clear that the equity curve trading approach is harmful. While steep drawdowns are stopped many times by the equity curve trading, significant upside trades also are missed, leading to a net effect of poorer overall performance. (Results for the E-mini S&P 500 strategy are shown in “E-mini S&P 500: Equity analysis,” below.)

 

Equity curve trading for the E-mini S&P 500 strategy is better for the moving average approach, but worse for the new low approach. The degree of improvement is highly dependent on the choice for the look back period. There is no “one size fits all” approach for this particular strategy. (Results for the Japanese yen strategy are shown in “Japanese yen: Equity analysis,” below.) 

As shown in “Japanese yen: Equity analysis,” equity curve trading for the yen strategy is always worse than just letting the strategy trade continuously, sometimes significantly worse. The new low technique is better than the moving average technique. Both methods underperform the “always on” case, sometimes by quite a large margin.

Base is better

For these three real-life strategies, the equity curve trading approaches do not improve performance, except in a limited number of cases. This highlights three important issues with equity curve trading. 

First, the results depend on the strategy being traded. Not every strategy will act the same for each method of equity curve trading. This can be seen in the contrast between the E-Mini S&P 500 strategy, where equity curve trading may improve performance, and the Japanese yen strategy, where equity curve trading never improves performance. 

Second, the choice of trading technique is also critical. It may be that one particular approach improves performance, but a different approach harms it. This is evident in the E-Mini S&P 500 strategy, where only the moving average approach improves the strategy.

Finally, even within one approach, the choice of parameter (the look back period in this case) for the equity curve trading has a large, but inconsistent, impact. This is clearly evident in the gold strategy, where a wide range of profit to drawdown ratios are possible, simply by changing the look back period.

Equity curve trading has its vocal proponents in the industry. But the overall efficacy of the approach is certainly not crystal clear. In fact it is relatively easy to take a good strategy and significantly degrade its performance by employing equity curve trading. 

While the overall objective of equity curve trading is unquestionable—to cease trading with poor performing strategies—it is probable that there are better ways of accomplishing that goal. This study indicates that equity curve trading with simple indicators has more downside than upside.    

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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.”