Equity Curve Analysis

Browse through the Collective2 website and have a look at the differing equity curve charts.

When your equity curve is looking fantastic - starts in bottom left and ends in top right - there is nothing to think about. Keep doing what you're doing.

But, during drawdown time, what to do? All systems have drawdown times. But is it just a drawdown, or has your system stopped working?

I gave the example of this chart on that Collective2 site a few posts ago. That system gained 500% over just a few months. Fantastic. And a few months after that it was in 100% loss territory.

The question is, if you were the person using that system, when do you stop using it? When it fell back to a 400% gain? When it fell back to a 300% gain? 200%? 100%? At zero?

So here again, we need some clearly defined, objective rules. It's not good enough to erase the "I'll just hold on for a bit longer - it'll come back" way of thinking from the trade exit, if you're going to be doing the same thing here.

In fact I think it's more crucial here than anywhere to be clear about when to stop using the system.

Now, there is this thing called Profit Factor. Here's what I've said about Profit Factor in a blog entry:

Profit Factor is (Av Win / Av Loss) * (Pct Winners / Pct Losers). If it equals 1, the system has neither lost nor made money. If it's less than one then the system is losing money, more than one and the system is making money. The bigger the number, the "better" it is. But this calculation falls down in that it doesn't take into account the total number of trades, or the total amount won/lost.

(5/4) * (55/45) equals (500000/400000) * (55/45).

It does.

Really.

Anyway, you could use the Profit Factor of the last 5 or 10, or however many, trades to determine if you will continue to use your system. Once the Profit Factor falls below your set level, you continue to track the trades, but do not actually trade them. When (if) the Profit Factor comes back above that level, you can then start making real trades again based on that system.

I dare say that poor "500% gain to 100% loss" chap could have benefited from something like this.

On the other hand, here's something I also said about this method in a previous post:

...just because the last 5 trades have a Profit Factor of 2, doesn't mean the next trade is going to be any good. In fact, a scenario of events could take place where this rule keeps you out of the good trades and let's you get in on all the bad trades.

In the scenario I'm talking about, you have some bad trades, so the Profit Factor falls below the set level. Then, while you are paper trading, you get some good trades, so the Profit Factor comes back up. You now start real trading again, but have some bad trades. The Profit Factor falls below the set level. Then, while you are paper trading, ... repeat.

This Profit Factor idea is not bad, but it's not perfect. More research is required.