What is equity curve trading ?

Timing is everything in equities trading. How can you tell if you've held onto a trading strategy longer than you should?

One of the most popular trading strategies is the equity curve strategy. This involves following an equity curve to determine when it is time to press pause.

What is an Equity Curve?

An equity curve shows how your trading account has changed over time. It shows you graphically if a trading strategy is working. You can put a plan on hold if it doesn't pay off within a certain time period based on the equity curve. If the equity curve has a positive slope, it means that the strategy is paying off. If the slope is negative, it means that the strategy didn't pay off during the period.

An Example of an Equity Curve

Let's look at an example of an equity curve that includes two strategies.

Investor A has Rs.50,000 in trading accounts. His approach returned him decent profits between January and May. However, since June, he has been suffering net losses. The first column shows the months A traded with strategy 1. The second column is his monthly net profit or loss. The third column is his cumulative profit. Finally, the third column shows how his trading account has grown, based on his profit or loss for each month.

You can plot the equity curve based on either the cumulative profit or loss, or the trading account balance. Both strategy 1 and strategy 2 will be plotted separately to show how the graph looks.

Based on trading account value, Equity Curve for Strategy 1

It is possible to see how the equity curve has changed over the time period January through August.

You can also create an equity curve by plotting cumulative loss and profit for the strategy.

Let's say that investor A decides strategy 1 is not worth his time since it has stopped making money. He decides to use a different trading strategy, which isn't immediately profitable, but eventually begins to make him money as the markets turn. Let's plot the equity curve of strategy 2.

Let's first plot the equity curve of strategy 2, based on changes to the trading account value.

Equity Curve for Strategy 2's Trading account Value

The EC plotting changes in cumulative profit or losses for strategy 2.

Equity Curve is based on strategy-specific cumulative profit or loss.

As you can see, the graph shows that the inflexion points for the second strategy are clearly visible. In August, the cumulative gains are positive. However, the approach begins to reduce its losses from June.

What is Equity Curve Trading?

Equity curve trading involves traders applying a moving mean to the curve. When the equity curve falls below the moving average, the strategy should be put on hold. This is done in order to stop losses when traders realize they cannot afford additional losses or when their hopes of the strategy working dimming. When the equity curve is above its moving average, the trader can resume trading that particular strategy.

Conclusion

Equity Curve Trading gives investors the assurance that their investment will be covered, even if they are not actively following their strategy. If the equity curve falls below an investor's comfort level, it can be stopped until the equity curve reaches the established moving average.