In an effort to limit the drawdown of a trading system I like to employ a filter on the strategy’s equity curve. Meaning that if the strategy runs into a rough period I have a set of objective rules that tells me when I should take the strategy offline.
The most common type of filter I employ for the equity curve is based off of a 100 trade moving average of the curve. When the equity curve is trending above the average the system remains active, when the equity curve drops below its average the system is taken offline until the curve turns upward again.
I typically trade mean-reversion type strategies which have a typical trade distribution with many small winning trades with the occasion large loss. The trades are also short in duration with anywhere from 3-12 trades per day placed by each strategy. Its after a string of large losses occurs that the curve will drop below its moving average. This type of filter would not work with a typical trend following strategy which would have many small losses and the occasional large win as the filter would likely take the strategy offline before it has a chance to place one of its few winning trades.
Below is the equity curve of the AUD/NZD strategy which I have been trading for much of the year along with its 100 trade moving average. Recently the strategy has experienced a drawdown which erased nearly all the gains that had been earned through the year. The goal is to attempt to reduce the severity of the drawdowns.
If the strategy is turned off when the equity curve drops below its 100 trade moving average we end up with the following result. As can be seen, when the strategy is in an uptrend the filtered equity curve provides a slight drag on profitability. But once the equity curve takes a noticeable downward turn
Just so we’re comparing apples to apples, the stats for the unfiltered strategy will start at trade 100 (which is where the 100 trade MA starts). The moving average filter cuts nearly half the trades out over the time period, reducing the drawdown by nearly 50%, as well as increasing the system profit by 37%.
| Original | Filtered | |
| Trades | 432 | 226 |
| Avg. Trade (Ticks) | +0.31 | +0.83 |
| Total Profit (Ticks) | +135.7 | +186.8 |
| Max Drawdown (Ticks) | -443.6 | -226.90 |
In theory one could apply any number of technical indicators to a strategies equity curve in an effort to help improve its profitability, as well as to make a determination if a strategy has stopped working and should no longer be traded. I also blogged in the past about tracking the overall equity curve of a trading account which is trading a portfolio of strategies and move excess funds into and out of the account.
http://limituptrading.wordpress.com/2011/04/16/surfing-the-equity-curve/
I am continuing research on this topic and will be exploring other possible means for determining when a strategy should be disabled or should be removed from a portfolio all together.
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twitter: @RobTerp
