A concept that I thought of while showering a while back was treating an equity curve of a trading system as a tradeable security. It is analogous to using tactical asset allocation, except on trading systems instead of a portfolio of assets. Unfortunately for me, this is not a new idea. I also found this idea while going through the archives of my favourite blog, David Varadi’s CSS Analytics, and at Howard Bandy’s Quantitative Trading Systems in a post titled Equity Curve Feedback. So far, I’ve been able to think of four ways to apply this idea to a trading system, based on two types of equity curve feedback that I call “soft” and “hard” equity curve feedback.
- Soft equity curve feedback allows new trades to be entered when a certain equity condition is met.
- Hard equity curve feedback allows new trades to be entered when a certain equity condition is met AND forces new trades to be undertaken on the second derivative level while mid-trade on the first derivative level.
For example, say you are using an equity curve feedback rule that states that you will only trade when the the equity curve of System XYZ > 15 Day SMA of the equity curve of System XYZ . Your first trade on System XYZ manages to push the equity curve of System XYZ above its 15 Day SMA mid-way through the trade:
- With soft equity curve feedback entry, you are now allowed to trade System XYZ, but you do not enter the trade mid-way
- With hard equity curve feedback entry, you are now only allowed to trade System XYZ, but you also immediately enter the mid-way trade
With these two variations, we can come up with four different kinds of equity curve feedback overlays:
- Soft entry; Soft exit
- Hard entry; Soft exit
- Soft entry; Hard exit
- Hard entry; Hard exit
There are also two (three, but I don’t count one of them) forms of soft exits, but they aren’t different enough for me to classify it as an entirely different form of equity curve feedback.
- True soft exits – You cannot exit the system until the equity curve feedback condition is met. I do not consider this as a legitimate approach to equity curve feedback, since you are basically barred from exiting your system unless you are lucky.
- False soft exits – You can exit the system regardless of whether or not the equity curve feedback condition is met. You are not forced to exit your position if the equity curve condition turns from true to false, and you are still allowed to exit your position if the equity curve condition is false.
- Shorting soft exits – You can exit the system, but only based off of the inverse of your original trading system. For example, say System XYZ from above has the following rules
- Buy: X > 10
- Sell: X <10
- Short: Y > 10
- Cover: Y <10
- X and Y are random indicators
with the same 15-Day crossover equity curve feedback rules as before. You’re using hard entries and you entered in the first trade, but somewhere along the way the equity curve dipped below its 15 Day SMA. Now instead of exiting when X < 10, you exit when Y < 10. This only work if System XYZ has both long and short components, and you allow the shorting of the trading system itself.
From my experience (I’ve only played with it through back-testing, not live money. I’ve also only used simple SMA crossover trading strategies), equity curve feedback doesn’t really improve/detract from total CAGR (sometimes it improves/detracts but usually it maintains CAGR that is roughly similar), but it improves MDD and volatility.