Equity Curve Examples

Jul 18, 2007: 4:10 PM CST

I have provided you some examples of variables I used to demonstrate the need to use an Equity Curve Simulator to help you envision your possible trading results over time.

First, I am using a Reward/Risk Ratio (or an “Ave Win to Ave Loss”) of 1.5 (The average winner is 1.5x the average loser… maybe it’s $1,500 win to $1,000 loss on average each time). I am assuming a % Win (or % correct) ratio of .5 (meaning 50% of my trades were winners). For clarity, I will simplify this from now on in the following format:

Win/Loss Ratio: 1.5
Winning %: 50%

eg-1.jpg

Notice that on all trials (you can run this multiple times – I am running four trials), my equity grew each simulation. On two simulations, my equity grew by greater than 100% (this is over 453 trades).

For the next parameter, let’s assume the following:

Win/Loss Ratio: 3 (3 to 1)
Winning %: 30% (two out of three trades resulted in losses)

eq-2.jpg

In this instance, the results were a bit varied. I ran the simulator quite a few times and observed positive results in almost all trials. In this example, three trials result in outcomes that generate a 100% return on equity, while one outcome ‘breaks even.’ Rarely – though possibly – these parameters will result in a negative equity. Nevertheless, with winners being three times larger than losers, we can still achieve great profits when a paltry 30% of our trades result in profit.

Now let’s try this simulation:

Win/Loss ratio: .5 (meaning that Average Winning trades are 1/2 the size of Average losing trades… stated differently, our losers are twice the size of our winners)
Win %: 50% (1 out of 2 trades fail)

What do you expect will happen this time?

eq-4.jpg

You guessed right. We started up with the 100 box and ended below 0. This means we went totally broke after 453 trades (in fact, almost all simulations with these parameters end in the negative values!).

What this tells us is that if you let your results be dictated by mere chance (or even if your results are worse than chance), you will go broke if your losers are larger than your winners (over a period of time). In fact, there really weren’t many ‘upswings’ in equity in this simulation – it was almost all downhill from the start.

Why not try the following parameters yourself and see what happens:

Win/Loss Ratio: 10 (10 to 1)
Winning %: 15%

Win Loss Ratio: 5 (5 to 1)
Winning % : 25%

Win/Loss Ratio: 5 (5 to 1)
Winning %: 65%

Win/Loss Ratio: 2
Winning %: 60%

Try out your own combinations. You may be surprised.

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Equity Curve Generator

Jul 18, 2007: 9:30 AM 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.

Traders who have been around for longer than a few years know that the success or failure of a trader is due to holding fast to the ‘big picture’ of the overall system they have developed. 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 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.

Without going into further detail, I recommend you 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.

Have fun with this exercise! Check back this evening – I will be posting some examples for educational purposes.

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Quick Link: Risk – Reward Ratio

Jul 17, 2007: 9:49 PM CST

The Fresh Trader Blog recently simplified the concept of Risk/Reward Ratio into a simple post with informative graphics.

The blog is designed for newer traders and it offers very great basic information to get you started and provides references for more advanced students of the market.

Remember (quote):

In order to calculate the risk/reward ratio for any trade you make, you’ll need three numbers:

  1. Entry price
  2. Stop loss target price
  3. Stop profit target price

Check out the blog for the entire post, and many other resources for traders including a series on trading psychology.

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Dow Crosses 14,000 – What does it mean for Me?

Jul 17, 2007: 5:38 PM CST

Tim Paradis wrote a clenching article posted on Yahoo Finance this afternoon in regards to the Dow Jones crossing 14,000 for the first time. Specifically, he ponders “What does this mean for the average investor?”

Here are a few quotes from the brief article:

“While it’s true that such round-number milestones often draw big headlines and prompt some investors sit up and take notice of the market’s gains, most investors would be wise to pay attention to the moves of broader indexes like the Standard & Poor’s 500 index.”

“It’s meaningless for the average investors, although it can be a headline grabber,” said Dean Junkans, chief investment officer at Wells Fargo Private Bank.

“…watching the odometer flip to reveal a fresh set of zeros can also presage a pullback if it prompts some investors to lock in some profits.”

“You could have those folks say ‘It’s time to create a little dry powder and take some chips off the table,'” Junkans said. “It’s sort of overdue for a correction,” he said of the stock market.

“It’s just another number. I think it gets blown out of proportion,” said Neil Hennessy, president and portfolio manager at Hennessy Funds.

“There’s no euphoria,” he said. “Most people are aren’t paying attention because they don’t believe it. People just look for the negative.”

Absolute food for thought.

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This Week’s SFO – Psychological Issues

Jul 17, 2007: 9:21 AM CST

For those of you interested in Behavioral Finance or the Psychology of Trading, this month’s edition of Stocks, Futures, and Options Magazine contains plenty of information regarding these topics and more.

The cover article is entitled “Build Your Trading Brain,” and other articles in the magazine include the following:

“This is your brain on trading,”
“On the Hunt for Market Moods…,”
Behavior Economics: Most Take High-Risk Gamble to Avoid a Sure Loss,”
“Tech Take: Crowd Psychology and Market Turns,”
“Building Your Trading Brain – A Framework to Manage Thoughts, Emotions, and Actions”

Other articles address option strategies and commodity trading tips.

As a bonus, there is a great book review of Brett Steenbarger’s Enhancing Trader Performance. If you have not read this book at least twice yet, I strongly recommend you do so.

You can subscribe online at SFO Mag.com and receive the hardcopy, or go to your local newsstand/bookstore, or you can view each of these articles free online this month with registration.

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