Playing the equity curve: when it doesn’t help too much

04Jun12

I continue my developer diary with a post that illustrates that sometimes even a seemingly sensible Wall Street idea doesn’t help. One important investment advice is containing the losses. One way of this is the well know stop loss (fix percent or trailing stop loss). The problem with the stop loss technique is that it gives a timer when to exit the position, but it doesn’t tell you when to enter the position again once the position was stop lost. (Wait 2 months or what?).

 

There is one idea that helps similarly as a stop loss, but it exactly tells the trader when to enter the position again. It is a trailing indicator called ‘playing the equity curve’. (Albeit, it has various other names in other terminologies). The ‘equity curve’ is the Portfolio Value curve of the strategy. It can be any strategy (simple or complex, it doesn’t matter).

The basic idea is to play the strategy if it is above its 200 days moving average, and go cash or play the inverse strategy otherwise.

 

The method follows not one, but three portfolio value (PV) charts.

–          Original PV

–          EMA PV (Exponential Moving Average of the original PV)

–          Played PV  (is played in real life)

 

It seems it is a trend following method. When our strategy has strength, we play it, when it has some weakness, we stop loss it. All with a lagging indicator.

 

It only has 1 additional parameter: the lookback days of the EMA. (SMA can be used too).

 

Here is the original equity curve of a strategy over 8 years. It is a special volatility strategy, but in the context of this blog post, it doesn’t matter.

 

 

The human eye can ‘clearly’ recognize some patterns: the strategy worked in the first 2.5 years, then it stopped working for 3 years, then it worked again for 2.5 years.

We see 3 market regimes accordingly. In regime 1 and regime 3, we should play the strategy, and we should sidestep regime 2.

The ‘playing the equity curve’ technique will be a great help. Won’t be?

 

 

Version 1:

Be in Cash on the downside.

Let’s see when it is applied for 50, 75, 250 EMA values when under the EMA curve we are in cash.

(Click on the image to see it properly)

 

 

 

Did it help with the drawdown (DD)? Yes.

Did it hep with the profit? Not really.

Just let’s imagine that you started this strategy and in half a year it doubled your investment, then it didn’t give any profit for 6 years. Would you play this strategy? No.

 

The problem is that regime 2 becomes a too ‘neutral’ territory for our strategy. In regime 2 our strategy was not a winner, but neither a loser. The original curve flatlined.  And the EMA curve fitted onto it. Using a 75 days EMA parameter, in 75 days the EMA curve reached our original equity curve. In the next 4 years, we treaded water.

 

Version 2:

Let’s see the same EMA parameters, but instead of being Cash under the EMA, it plays the inverse-strategy.

 

 

 

 

 

We have huge drawdowns.

 

In theory, it seems that a long term EMA like 250 helps a little more, because there are less whipsaws. That is because the smooth EMA250 line only slowly reaches the equity curve of the original strategy in the problematic regime 2.

 

There are 2 problems with the feeling that the parameter 250 is the best and that we should we use this in the future. One is that selecting an optimal historical parameter is a kind of parameter overtuning. Because of some random chance, it turned out that this parameter was better.

Another one is that there is no guarantee that future bad (neutral) regimes (like regime 2) will take 3-4 years (as it was for regime 2), therefore it is unlikely that the EMA250 will be the best parameter in the future.

 

 

 

Conclusion:

I don’t have the magic solution right now.

The ‘playing the equity curve’ technique helped a little on the profit, a little on the volatility, but it was far from the success I expected.

One of the main problems is that investors would very likely stop the strategy after 4 years of treading water. I expected more from this technique. Maybe I expected too much.

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