System traders understand that their approach to trading requires nerves-of-steel patience while in a drawdown, gut-wrenching discipline in taking every signal generated by the system (and I mean every signal – no ifs, ands, buts or maybes) and cat-like reflexes in executing signaled trades before doubt can creep into the kernel regressing, quadratic equation. Whoever said that system trading takes the emotions out of trading doesn’t know the half of it. Doubters and skeptics of system trading recite the ‘past performance doesn’t guarantee blah, blah, blah’ mantra, refer to the perils of overfitting and data mining, and express a general independence from the enslaving nature of system trading. Well, you’ll be happy to know that you can be a system trader and not take every trade. How? Trade your equity curve.
Your system’s equity curve is how much money it’s making. Any standard package will be able to draw the simple chart for you. It has its ups and downs, with hopefully more ups for your sake. The goal for system traders is to create a smooth equity curve, meaning there are no radical departures from a gradually increasing trendline.
If your system’s equity curve looks sloppy and you can’t live with it, you either stop trading the ugly beast or you start a process of making it look better, which usually involves adding filters (to get the bad trades out) and other overfitting exercises. If you start down the path of overfitting so that everything looks neat and pretty, you might as well quit trading right now and donate your trading capital to a local charity. You’ll save yourself frustration and feel good about contributing to your community.
A natural tendency amongst system traders upon viewing an ugly equity curve is to revert to their discretionary trading habits. Take this trade, but not that one. It’s no longer system trading at that point, but discretionary trading with system tools. There is another way to maintain the integrity of the vast amounts of statistical data you acquired about your system during its development. And that is to code an algorithm to throttle or feed your system based on its equity curve performance.
I’ll offer three equity curves but instead of the naked one you’re used to viewing, I’ve added a MACD on a lower panel and two simple moving averages, a red one (50 day) and a green one (20 day).
The first one is a no-brainer. With an equity curve like this one, you want to keep trading it. Feed it, nurture it and read it bedtime stories.
It’s steadily climbing with the 20-day average nicely above the 50-day, and the MACD not showing any warning signs. If this is your equity curve, nice work.
Next, let’s look at one that may be in a little bit of trouble.
It has had a steep run-up just lately, but now the spread between the 20-day and 50-day is tightening to the point where the 20-day is threatening a breach of the 50-day. The MACD shows stalling momentum and a general decline.
Finally, let’s look at a not-so-pretty equity curve. This one has had its 20-day crossover its 50-day, and the MACD is confirming a deteriorating situation of steady decline and sub-zero line occupation.
Do yourself a favor, and let this system tell you what it’s going to do next before allocating anymore funds to it.
For system traders, it’s just a matter of programming when your system takes a trade or leaves a signal alone. You can program a moving average crossover or a host of other technical indicators that you may use in any typical trading system. You’re not being discretionary if you program under what equity curve conditions a trade is taken. The programming aspects involve creating a shadow or virtual system that follows along your regular system. I haven’t programmed one yet myself, but I know I can do it in TradersStudio. I’ll post the system once I’ve gotten it correctly coded.
Equity curves are not unlike stocks, and stocks are not unlike equity curves. That’s why we sometimes refer to stocks as equities. Your system is basically a stock that you’ve invested time and energy into. You can employ the buy-and-hold philosophy with your system, or you can trade it.
To emphasize the fact that you can view your equity curve just like you would any stock, ask yourself what favorite stocks the three equity curves above look very similar to. If you guessed AAPL, IBM and F, then you’re right.