Equity curves. If you’re like most traders, you can’t go a single day without checking yours.
Is it going up? Is it going down? Is it making new highs or new lows?
If you had a choice, you’d like it to go straight up, right? But we both know that’s not the case. If anything, your equity curve seems to have a life of its own, moving where and how it wants and there’s little you can do about it.
Or is there? Let’s find out…
What’s So Important About Equity Curves?
In case you don’t know, your equity curve is the graphical representation of your trading account balance and it shows you exactly how much money you have in your trading account at any given time.
If your equity curve is sloping up it means that your method is working and you are making money. If your equity curve is sloping down, then whatever you’re doing is not working and you are losing money.
And trust me, whenever people are making or losing money you can be sure that a lot of emotions are involved.
And that’s what’s so important about equity curves.
Not because of what they say, but how what they say seems to effect a trader’s emotions, decisions and ultimately that trader’s future performance.
But how accurate is the equity curve — and should you be focusing so much of your energy on it?
Let’s take a look at a few equity curve examples.
Equity Curve Examples
Now, when it comes to equity curves, there is no doubt in my mind that most traders would like their equity curves to look like this:
If you can’t tell, this chart represents a perfect equity curve. You would open your account and every trade from there on out would be a winner.
A 100% win rate. No losses. Only new highs.
A nice, perfect…fantasy. Because believe me, that doesn’t happen. In the market you will have losses. And when you first start trading you will have a lot of losses. And your equity curve will most likely be sloping DOWN.
Probably like this:
When I see an equity curve that looks like the one above I know a few things right away.
First, that the method the trader is using isn’t working…right now. It could be that this account is in a sustained drawdown period.
But honestly, if it has gone on this long it’s pretty bad.
The losers are probably a lot bigger than the winners. There are MORE losers that there are winners. And the trader is probably trading based on emotion.
But let’s not focus on losing methods right now. Let’s talk about how confusing the equity curve of a winning method can be!
To illustrate this, I want you to take a look at the following 3 equity curves:
Equity Curve #1
Equity Curve #2
Equity Curve #3
The first thing you should recognize is that these three equity curves come from a WINNING trading method.
More likely than not the winners are bigger than the losers, the trader knows how to let winners run and cut losers short and the trades are taken as part of a trading plan and not based on emotions or hunches.
What you might not have recognized, however, is that these charts are all pulled from the SAME trades, over the SAME time period and they all end in the SAME dollar amount gain.
So how is this possible? For one very simple reason — that the distribution of returns for any given method is completely random.
And THAT is what can be so confusing about equity curves. The same winning method and the same winning trades can create different equity curves depending on how those returns are distributed.
Maybe you will get a string of winners right out of the gate. this will create an equity curve that shoots up at first and then tapers off, like equity curve #3.
Maybe you will get losers right off the bat and your equity curve will slope down at first like equity curve #1. The truth is, you don’t know.
Simply put, we don’t know if the next trade is going to be a winner or a loser. We don’t know if it’s going to be a big winner or a small winner. We don’t know anything about how the returns will be distributed.
We can know approximately how many winners we will have and their size and the same for the losers — but that’s about it.
All we can know is if our method is a winner OVER TIME. We have to let our trades play out while we stay calm and log results and in the end analyze the data.
So What does all of this Mean?
It means this: If you are trading a system and you run into a patch of losers OR winners — it means nothing. What matters is the performance over time and whether or not your method has an edge.
That’s all that matters.
Finally, I want to ask you one last question: Would you ever trade a system that had a 65% LOSS rate? Meaning, every 6.5 times out of 10 that you traded you would loose? And you would win about 3 times out of every 10.
Could you trade that method?
I think it’s safe to say that most traders would not trade a system like that due to the fact that it would be emotionally uncomfortable to lose that much.
Which is a shame, because their equity curve could look like this:
As you can see, this equity curve beats out all of the others and loses MOST of the time. Crazy, right?
To learn more about the random distribution of returns and other ways that your mind can mess with you while trading, I urge you to read Trading in the Zone by Mark Douglas.
You will never look at the markets in the same way again.