The Equity Curve Technique

A foundation for short-term trading success

I would like to describe a cornerstone trading management system: "The Equity Curve technique" – which for convenience, I’ll also refer to as ‘EQT’ in this article. Of all the techniques I've adopted in the long road of learning to trade consistently, EQT is one of the most valuable I can share. As a trader seeking to make and keep profits in the market, the condition of your "equity curve" is really all that matters!

Success in trading depends not so much on having enough capital, but from using it properly. Adopting EQT as the master framework that drives and informs your trading activities can allow you to manage your capital more effectively. It can serve as the foundation in analyzing your trading money management parameters (such as maximum risk per trade, maximum drawdown, risk-adjusted return, etc.). Consistently, repeatedly we hear from the top traders and trading experts that "money management" is by far the most important aspect of trading to master. EQT can serve as the master-tool that will give you the visibility that you need, to bring good money management practices into play in your trading.

Adopting EQT can serve to dramatically improve your trading performance whatever vehicle you are trading whether it's stocks, options, or bonds. You can be a scalper going for hundreds of 1/16ths a day, an intraday "swing" trader going for a few points at a time, a 3-5 day swing/position trader, or a longer-term swing/position trader. It doesn't matter which - this technique can be effectively used with all types of short-term trading vehicles and trading styles.

For the longer-term investor, an equity curve is still useful, but some of the points in this article are less relevant, since the investor has much less control of the day to day fluctuation of security prices. In general, the shorter-term your trading period, the more suitable EQT can be. However, EQT can be adapted to the longer-term position trader or investor’s benefit, by changing the timeframes and the way the curve is interpreted.

For the profitable short-term trader, maintaining an equity curve can enhance performance and provide valuable feedback towards reaching profitability goals and objectives. For the struggling trader, this can be a difficult technique to adopt and stick with, simply because "the bad news" will no longer have anywhere to hide! However, if you are going through a difficult learning curve with your trading, or experiencing short-term difficulties, adopting EQT (along with keeping a trading journal, the subject of a later article) can be pivotal in helping you to correct trading errors or improve your technique.

The EQT Technique

To create a 30-day rolling equity curve, simply read your net equity off of your broker's web site after the close (or, if you are carrying positions, mark all of them "to market" at the end of every trading day) to enter an accurate "Net Account Equity" figure into a spreadsheet. For multiple accounts / brokerages, simply add the account balances; or keep a curve for each account (and a "rollup" curve).

There are many possible refinements to this, but the key idea is to plot your account value, marked-to-market if you carry positions overnight, every day after the market has closed and to plot / monitor this curve on a regular basis. Studying this curve daily is an essential psychological component of the EQT concept and is part of what makes it so surprisingly powerful, as explained below.

I recommend keeping the equity curve charted on a 30-day rolling basis. After updating the data, take five minutes to study the updated equity curve, which is essentially your trading performance, good or bad, plotted clearly on a chart. If you are interested in moving towards peak trading performance, then I recommend examining the chart carefully each time it is updated -- computing the slope; measuring the drawdowns, and in general lingering long enough to be sure the data you're looking at gets into your subconscious thinking.

Things you should be looking at include:

• Slope of the curve. Measures your average gross, pre-tax profit per day -- positive correlation to performance, and generally, inverse correlation to risk.
• Size of drawdowns (a fancy name for losses). Aggressive traders – there are a lot of ‘learns’ here. Drawdowns take time to overcome.
• Recovery time from drawdowns. Motivation to minimize risk per trade, per classic money-management theory.
• Scalability of your trading style. Are profits growing as equity grows? Is your trading style going to continue to work as you trade a larger account?
• Risk-adjusted return. Are you taking on too much risk? Are the rewards commensurate with those risks? Often, trading more conservatively will yield higher returns over time.

Divide your estimated annual rate of return by the risk, to arrive at risk-adjusted return. Use any of the following for measuring risk: a standard deviation of monthly equity changes; average maximum retracement in your equity curve, or the largest drawdown from an equity peak (I prefer the latter).

Notice how the equity curve is plotted as an area chart. As a short-term oriented trader, of course you are primarily interested in the trend and slope of this curve, ideally seeking to conduct our trading operations in a way that the chart is either ‘flat’ or ‘up’ every day. The inevitable drawdowns (setbacks measured from the previous peak in equity) that occur in any form of trading show up on the charts as "dips". It pays to analyze these dips and to think about their depth, duration, and why they occurred -- e.g. trading errors, tough market environment, rules broken, etc.

Position traders will have to take a little longer-term view and the individual days may be a little more subject to the whims of the market. Longer-term investors that employ this technique you may want to update the curve on a weekly or monthly basis. After keeping an equity curve for a while, investors may also decide to become short-term traders -- as the equity curve will expose the weaknesses of a buy-and-hold approach! Investors are constantly making and the giving back short-term profits, as their investments rise and fall with the market. Another thing for longer-term investors to consider is that during periods of sharp market selloffs, short-term traders are often making their largest profits, shorting them aggressively right along with the best of the Wall Street institutions, hedge funds, and money managers.

Being a trader, vs. being an investor, is all about having control of your equity curve, versus being "at the mercy of the market". Trading your funds without using some form of equity curve to monitor performance is analogous to flying an aircraft with a blindfold, and can lead to similar results!

A note about mechanics

The equity curve is really a cumulative gain/loss curve; therefore deposits or withdrawals to your trading account should be adjusted out. This can be done with an adjusting entry at the start of your data that moves the whole curve up or down, but does not reflect the gain/loss curve over the period of interest. Just adjust the Y-axis up or down (at the 1st day) as appropriate; what you want to focus on is your trading performance, not your withdrawals and deposits.

As far as the period to use on your equity curve, I find 30 days to be the best time period to monitor, however shorter or longer-term equity curves can be useful (there is no reason you can’t monitor multiple time frames).

Instead of a spreadsheet, you might decide to keep the data in a charting package as an open-high-low-close (OHLC) or Candlestick chart format, with manually entered data. Then you can apply technical indicators to the chart, and set objectives like "keep equity curve in an uptrend, above 20-day moving average ". This makes it easy to keep track of intraday equity volatility as well. I have seen some advanced articles that go in to the theory behind applying technical analysis - moving averages, etc. to the analysis of equity curves! Which makes you think.

If you use an Excel workbook file to do this, take note that you can easily store an entire year's trading days into a workbook at one trading day per Worksheet (tab), with rollup (summary) sheets and charts on their own pages (Worksheets). An Excel workbook can easily hold over 500 Worksheets, each of which might represent a separate day of trading. For direct access traders using Realtick III, you can use the Excel files that RT III generates on your hard disk. It is simple to link data from an individual Worksheet, to a rollup sheet. I am in the process of developing a series of Macros, DDE linking, etc. to enhance and automate my system of equity-tracking spreadsheets; it can become quite involved. But remember, a paper and pencil are adequate!

The Rationale: Performance Psychology

Why can routinely keeping an equity curve and monitoring it closely make a
difference in performance? There are a number of reasons, but I believe primarily it boils down to psychological feedback, on both the conscious and unconscious level.

You may notice as you start to use an equity curve that you feel under pressure to perform, and that you are less likely to take trading days off. Once you've acquired and mastered the key skills to trade successfully, with this kind of feedback you can push yourself as hard as you'd like.

Many of us drawn to short-term trading are by nature very competitive, goal-achieving types of individuals. But there is also a natural human tendency among traders to deny or overlook problems or shortcomings. Once you adopt EQT, any trading problems will quickly become very obvious and undeniable. This is important, as often (almost by definition) the trader’s conscious mind is "in denial" about bad positions and/or trading problems.

For example, a trading strategy with too large of drawdowns will force you to spend much of your trading energy "making back" losses; a more conservative approach might produce higher returns over time. If you watch your equity curve, this sort of thing will become quickly obvious, leading you to an improved trading style. Similarly, the hazards and price of trading too large of positions (a very common error among beginners) will quickly show its footprints in a trader's equity curve.

Probably the most powerful and interesting impact of using EQT occurs due to subconscious processing of the equity curve data. If you go through the process of studying, updating, and consciously focusing on the curve every day, you will find that some great ideas to improve your trading can will start to appear out of nowhere, even though you haven't been "thinking" about it. This is a result of the powerful subconscious at work; the equity curve becomes a sort of "flash card" feedback system.

With the feedback provided by an equity curve you can move yourself to much higher levels of trading performance, should you choose to do so. For the moderately aggressive to conservative trader, the equity curve can serve as a tool to motivate you to minimize drawdowns, encourage you to stay 'flat' (out of the market) when the market is erratic or the good risk-reward trades aren't there, and to keep you consistently motivated to bring in the profits.

As you adopt this technique you may find yourself becoming more goal-oriented, which can improve trading discipline and performance. In many ways, high-performance trading is similar to (and can feel like) training for a high-intensity competitive sport. Higher trading returns, like shorter times in the Marathon, don't come without increased some increased pressure and stress on yourself. Using EQT you are equipped with the tools to decide how hard you want to work, what level of trading intensity is comfortable, and what kind of returns you are seeking; you can then set your trading business objectives accordingly. EQT is the right kind of "instrument panel" for a short-term trader – that’s why it’s become my cornerstone performance-monitoring technique.