In equities trading, timing is everything. How do you know when you have held on to a trading strategy for longer than you should have?

Among the various trading strategies, a popular one is the equity curve trading strategy where the trader follows an equity curve to decide when it is a good time to press pause.

What Is An Equity Curve?

An equity curve is a visual or graphical depiction of how your trading account has grown over time. To put it simply, it shows you graphically whether a particular trading strategy is paying off or not. Based on how the equity curve looks, you can choose to put a plan on hold when it hasn’t paid off in a predetermined time. So, for example, if an equity curve shows a positive upward slope, you know the strategy is paying off. If the slope is negative, then you know that, during the given period, the strategy hasn’t paid off.

Example Of An Equity Curve

Let us understand an equity curve using a simple hypothetical example that consists of two different strategies.

Investor A has a trading account of Rs.50,000. Between January and May, his approach has returned him decent profits every month, but since June, he has been incurring net losses. In the first column on the left are the months A has traded with strategy 1, second left column is his net profit or loss each month, the second column from the left is the cumulative profit, and the third column is how his trading account has grown based on the profit or loss each month.

 Month Net Profit/Loss (in rs.) Cumulative profit/loss (In Rs.) Trading Account Value (in rs.) January 2000 2000 52000 February 4000 6000 56000 March 6000 12000 62000 April 8000 20000 70000 May 10000 30000 80000 June -5000 25000 75000 July -3000 22000 72000 August -4000 18000 68000

The equity curve can be plotted based on the cumulative profit or loss or the trading account value. We will see how the graph looks for strategy 1 by plotting both separately.

Equity Curve For Strategy 1 based on the trading account value

 Month Trading Account Value (in rs.) January 52000 February 56000 March 62000 April 70000 May 80000 June 75000 July 72000 August 68000

You can see how your equity curve has moved over the period between January and August.

Similarly, you can have an equity curve by plotting the cumulative loss or profit of the strategy.

 Month Cumulative profit/loss (In Rs.) January 2000 February 6000 March 12000 April 20000 May 30000 June 25000 July 22000 August 18000

Now suppose investor A decided that strategy 1 is no good since it has stopped paying off. He employs another trading strategy that is not immediately profitable but eventually, as the markets turn, begins to return profits for him. Let us plot the equity curve for strategy 2.

 Month Net Profit/Loss (in rs.) Cumulative profit/loss (In Rs.) Trading Account Value (in rs.) January -2000 -2000 48000 February -4000 -6000 44000 March -5000 -11000 39000 April -6000 -17000 33000 May -7000 -24000 26000 June 5000 -19000 31000 July 10000 -9000 41000 August 15000 6000 56000

Let us first plot the equity curve for strategy 2 based on changes in the trading account value.

 Month Trading Account Value (in rs.) January 48000 February 44000 March 39000 April 33000 May 26000 June 31000 July 41000 August 56000

Equity Curve For Strategy 2’s Trading Account Value

Plotting the EC for changes in cumulative profit and losses for strategy 2.-

 Month Cumulative profit/loss (In Rs.) January -2000 February -6000 March -11000 April -17000 May -24000 June -19000 July -9000 August 6000

Equity Curve based on cumulative profit or loss for strategy 2.

You can see from the graph; the inflexion points are distinctly clear for the second strategy here, that is, in August the cumulative gains are positive, though the approach starts reducing its losses since June.