Generate Your Own Equity Curve (Simulator)

Jul 22, 2008: 5:11 PM CST

TechnicalTrades.net offers traders an Equity Curve Generator algorithm/program for you to input parameters into the formula and randomly simulate outcomes that could be representative of your trading system.

Generally, the success or failure of a trader is due to study of the overall system they have developed personally, and diligent application of that system in the larger picture; individual trades really do not matter, especially when they become one point among hundreds of ’spots’ on an Excel Spreadsheet or some other graphical program that demonstrates equity curves or probability distributions.

There is a Catch-22 regarding evaluating your trading system: You must know a close estimate of your win/loss ratio as well as your % win (or probability of a winning trade) to evaluate your results over a long enough time frame, depending on how frequently you trade. In other words, you won’t truly know how your system performs until you gather sufficient data – trades – to generate a proper %win ratio and win/loss ratio.

One major solution to this dilemma is to run various parameters you think may be closest to your chosen system through an Equity Curve Generator algorithm. The above link provides such a simulation.

The page gives you instructions, but you need to know ( or “toy with”) the following:

1. Ave Win divided by Ave Loss (Win/Loss Ratio).
2. Win percentage

The Win/Loss ratio is derived from an average of each trade. Remember that to enter a ‘good’ trade, you should strive to make your profit target a key value larger than your downside (or protective) stop. You can set this ratio to be exactly 2:1, where your profit target will be exactly two times your stop.

In other words, if a stock trades at $50 and you believe you can get an upside target of $55, then you would place your stop at $47.50 ($2.50 less than the current entry). This is a bit mechanical, and doesn’t really test out in the real world, but it gives you an idea of how to achieve relative consistency with the win/loss ratio.

Keep in mind that most traders will tell you to strive for a 3 to 1 profit to loss goal on every trade, but sometimes this is impractical. Sometimes you may find a 1 to 1 profit to loss parameter to be acceptable, but you will need to consider the second variable – % correct – in order to evaluate this.

The Win Percentage (or “Win Rate”) tells you – on average – how many times you hit your profit target vs. your downside stop. In other words, how many times on average do you take some profit vs taking a loss due to a stop?

Don’t get over-eager – be realistic. Unless you are a position trader or investor, you’re not likely to get many 10 to 1 risk/reward ratio readings, or you might not even get many 5 to 1 (especially if you are a scalper or day-trader).

Also, be realistic in that ‘pure chance’ is a .5 % win (this translates to a 50% chance that a trade will succeed). I do not recommend you get into the simulator and type in anything above 75% unless you want to amuse yourself and see what the numbers would be like. There is too much volatility or things that you cannot predict in the market in a given position, and it is extremely difficult to sustain a high winning percentage for a long time. Realize that most professional active traders achieve in the neighborhood of 40% to 60% win ratios – let this be a sobering thought.

Visit the site and play around with these two variables (ratios).

The bottom line that you should learn from this exercise: You do not have to be perfect to make a lot of money in the markets. The key is consistently letting your average wins be larger than your average losses, among other considerations.

Have fun with this exercise!

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