Once you’ve got a large number of trades under your belt, and have kept accurate track of them over time, you can start using many of the indicators you apply to the markets to your account data. This will help you analyze and improve your trading.
But, in order to do that, you have to get a good appreciation of your equity curve.
If you make a spreadsheet of your trades, you can turn it into a graph, tracking the growth (and hopefully not too much lack of growth) of your account balance. After a few hundred trades, it will look a lot like a graph of the market performance, which is really useful when it comes to studying it.
The Rollercoaster of Trading
Now the markets go up and down, and so can your trading account. If you plot your equity curve, and it’s pointing downwards, it’ll likely give you a sinking feeling. Occasional downs, especially after ups, are normal for any kind of trading. But we want the trend to be going UPWARDS.
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An equity curve that is trending upwards has a profit factor over 1. This means you are making money in the long term. An equity curve that trends downwards, has a profit factor of less than one and is a warning sign that you need to seriously reevaluate your strategy.
What to Do
Standard practice is to use a moving average along with your equity curve to give you a heads up that your trading strategy needs tweaking. This can help you adapt to market changes and save money.
The thing is, in normal trading situations, when you implement a strategy and start trading, your first few trades are likely going to fluctuate as you get used to the situation and tweak your strategy a bit.
But, if things are how they are supposed to be, your account balance should start trending upwards. It will bounce up and down depending on market conditions, of course, but you should have an idea of a long-term positive trend.
Where to Set the Limits
The problem is that you might not know when your account is just going up and down, and when it’s actually trending. That’s why it’s useful to apply a simple moving average to your equity curve.
Not only does it help visualize the trend, but it also allows you to set up “stops”. If the curve retreats back to the moving average, you can immediately see that this drawdown is bigger than normal, and you might want to revisit your strategy.
How much of an interval you should set for your moving average will depend on how much of a drawdown you can accept. While there are statistics to show what’s the ideal potential loss for individual trades, the level of drawdown that you should expect often depends on your personal trading experience, psychology, and strategy.
Traders with high variance in their results would likely set a larger interval in their simple moving average to get a more accurate reading on where their profitability is trending (such as a 100 or 200 SMA). On the other hand, if you tend to be pretty consistent in the kind of results that you get, a shorter interval, so you can get a quicker warning that something is off with your trading (like 50 to 100 SMA).