Save Money Using Equity Curves

By: Dan Underhill
For those who rely on day trading or swing trading to provide an ongoing income stream into their account portfolio, much time is spent learning all the aspects of trading their own systems effectively. Priority is spent of developing techniques surrounding how to improving their win rate which is certainly time well spent, however there is another side of the equation that a minority of investors and traders should devote time to understanding. That is effective money management. How to develop a plan that can deal with the inevitable times when losing streaks occur can make the difference between staying in the game and blowing out your trading account.

Anyone that has traded futures, options, stocks, forex and commodities in a short term time frame can tell you from experience that losses are guaranteed part of trading. There is no way around it. Even if you are trading a system, or a plan, that has a 60% win rate, you can still expect that 4 out of 10 of your trades are simply not going to work. These are probabilities that we must acknowledge. And what if these 4 losing trades occur in a row? What if 8 of these losing trades occur in a row? This can deliver a sizable blow to your portfolio even though the long term probabilities of your trading plan demonstrate a 60% win rate.

Even if your entrances to your trades are perfectly executed according to your trading plan, the follow through due to market mechanics may not provide the desired result due to no fault of your own. However, nobody executes their trading plan 100% flawlessly because as humans we are prone to make mistakes, enter trades late, enter too early because of emotions, etc. So factoring these in to the equation, this brings our win rate down even still.

So how can we, as traders, help to stack the odds in our favor even more that our accounts will be protected when losing streaks occur? One of the best techniques in place for mitigating losses affecting your equity is called Equity Curve Trading. Equity curve trading is a system that simply plots your ever-changing account equity against its own moving average, and then trading decisions are based upon the interaction of your equity line with the moving average.

How can this help? Professional system traders have used this concept for a long time, and many auto-trading computers utilize this simple technique to recognize when the trading program has experienced too many losses. With equity curve trading, once a threshold of losses is recognized, all live trading (trading with real money) is ceased and all future trades are taken in a simulation mode. Results of the simulated trades are still recorded in the equity curve as if they were live trades, but no real money is being risked until the equity curve shows that you are back on a winning cycle of follow through.

Let’s explore a simple example of how this would work. I won’t get into the details of explaining what a moving average is because I assume if you are reading this you already have an understanding of that. To begin with, we start by logging the profit and loss amounts of each of our closed trades in relation to our account’s total equity. If our account is worth $20,000 and our next trade is a $200 winner, then we plot a point at $20,200 on a graph and connect the two points with a line. Our next trade may be a $100 loser so we plot a point at $20,100 and draw a line connecting the last two points. This begins to develop jagged line representing our changing account equity.

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