Only Trade the Best Segments of the Equity Curve – Cut Out Drawdown and Take Advantage of Run Ups! Really?

Equity curve feedback has been around for many years and seems highly logical, but one can’t get an industry-wide agreement on its benefit.  The main problem is to know when to turn trading off and then back on as you track the equity curve.  The most popular approach is to use a moving average of the equity curve to signal system participation.   When the equity curve moves below 30, 60, or 90 period-moving average of equity, then just turn it off and wait until the curve crosses back above the average.  This approach will be investigated in Part 2 of this series.  Another approach is to stop trading once the curve enters a drawdown that exceeds a certain level and then start back up once the equity curve recovers.  In this post, this method will be investigated.

Programmers Perspective

How do you go about programming this tool to start with.  There are probably multiple ways of accomplishing this task, but the two I have most often observed were the two pass process and the inline simultaneous tracking of the synthetic and actual equity curves.  The two pass process generates an unadulterated equity curve and stores the equity and trades either in memory or in a file.  The second part of the process monitors the external equity curve along with the external trades synchronously and while trading is turned on, the trades are executed as they occur chronologically.  When trading is turned off, the synthetic equity curve and trades are processed along the way.   The second method is to create, which I have coined (maybe others too!), a synthetic equity curve and synthetic trades.  I have done this in my TradingSimula_18 software by creating a SynthTrade Class.  This class contains all the properties of every trade and in turn can use this information to create a synthetic equity curve.  The synthetic equity curve and trades are untouched by the real time trading.

Start Simple

The creation of an equity curve monitor and processor is best started using a very simple system.  One market algorithm that enters and exits on different dates, where pyramiding and scaling in or out are not allowed.  The first algorithm that I tested was a mean reversion system where you buy after two consecutive down closes followed by an up close and then waiting one day.  Since I tested the ES over the past 10 years you can assume the trend is up. I must admit that the day delay was a mistake on my behalf.  I was experimenting with a four bar pattern and somehow forgot to look at the prior day’s action.  Since this is an experiment it is OK!

if marketPosition <> 1 and 
(c[2] < c[3] and c[3] < c[4] and c[1]  > =  c[2]) then 
	buy next bar at open;

//The exit is just as simple - 
//get out after four days (includeing entry bar) on the next bars open - no stops or profit objectives.  

If barsSinceEntry > 2 then sell next bar at open;

Here is the unadulterated equity curve using $0 for execution costs.

The Retrace and Recover Method

In this initial experiment, trading is suspended once you reach a draw down of 10% from the peak of the equity curve and then resumes trading once a rally of 15% of the subsequent valley.  Here is an intriguing graphic.

I did this analysis by hand with Excel and it is best case scenario.  Meaning that when trading is turned back on any current synthetic position is immediately executed in the real world.  This experiment resulted in nearly the same drawdown but a large drop in overall equity curve growth – $75K.

Put the Synthetic Equity Curve Engine to the Test

Now that I had the confirmed results of the experiment, I used them as the benchmark against my TS-18 Synthetic Trade Engine.  But before I installed the Equity Curve algorithm, I needed to make sure my synthetic trades lined up exactly with the real equity curve.  The synthetic curve should align 100% with the real equity curve.  If it doesn’t, then there is a problem.  This is another reason to start with a simple trading strategy.

Take a look here where I print out the Synthetic Equity curve on  a daily basis and compare it with the end result of the analysis.

Now let’s see if it worked.

The equity curves are very similar.  However, there is a difference and this is caused by how one re-enters after trading is turned back on.  In this version I tested waiting for a new trade signal which might take a few days.  You could re-enter in three different ways:

1. Automatically enter synthetic position on the next bar’s open
2. Wait for a new trade signal
3. Enter immediately if you can get in at a better price

Using the 10% Ret. and 15% Rec. algorithm didn’t help at all.  What if we test 10% and 10%.

Now that performed better – more profit and less draw down.  Now that I have the synthetic engine working on simple algorithms we can do all sorts of equity curve analysis.  In the next installment in this series I will make sure the TS-18 Synthetic Engine can handle more complicated entry and exit algorithms.  I have already tested a simple longer term trend following strategy on a medium sized portfolio and the synthetic engine worked fine.  The retracement/recovery algorithm at 10%/15% did not work and I will go into the “whys” in my next post.