Starting A Strong Equity Curve

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Starting A Strong Equity Curve

24 October 2020

Yesterday was more of a normal day as my win streak came to an end :( Every week or so I catch a 6-10 trade streak that helps keep the balance of statistics in place for my 80% average. This balances off maybe a day or two of lackluster results. I often see people beating themselves up for a series of trades emotionally that they do not see objectively and that can cause them to do very very stupid things. Such as over leverage in order to make up a loss, overtrade because they had a series of losses or are down. All of this is an emotional response to something you have no control over. This is where discipline and habit will save you a great deal of roller coaster to flatline results. As in nature things are reflective so big ups and downs equal the opposite as well which would be very little movement in your equity curve. The goal in trading is singular to create a positive equity curve, most people are focused on so many other things but the foundation of what you are trying to do is singular. What does a positive growing equity curve say about all other aspects of your trading? They say this – consistent – methodical – disciplined – balanced – money management – stable – adaptive – < WINNER >Everything you do will be reflected in your equity curve/bottom line. This is why its important to focus on it, because it tells you exactly what is going on with you and your trading. After I go through my trading day yesterday I will continue with some healthy habits for making a strong equity curve.

To start the day off with I had an EU buy from 6:54 to 7:00 am a very tight window of 6 mins, the actual signal was a bit longer till 7:02 but the expiry time I could get was right @7am and I would not have taken it to 7:05 expiry so I was just able to get the entry on this trade. It was a very unremarkable trade and from the way the price was so lathargic to begin with I was a bit worried the day would continue like this, which it did not. I went into protection mode and reduced my leverage to 2% a trade. Though this trade was ITM by its conclusion I was not happy with the price action being demonstrated.

This Dax trade was a much cleaner setup then the EU trade demonstrated before and all the elements I look for were in perfect synchronicity, still I did not get much of a move the range again was restricted. Yet it was valid and ended the call option in the money, so you can’t argue with success. Still used less leverage on this trade around 2%.

My best trade of the day – the DOW POW! This trade had every element perfectly in sync on the 10sec 1min 5min all in alignment showing the same exact thing, a very STRONG UP coming. This trade I had no choice but to take the full 5% of max leverage due to it being absolute PERFECT. I timed it exactly for 2pm expiry waited for after 1:50 to get the call options for 2pm expiry and as you can see it was on the money for in the money! I screamed this one out in the chatroom at the top of my lungs lol and some of my friends caught this and were ecstatic as was I :) A really stunning example of a perfect ALGO entry for me. Not a 100% day but I have no control over that ;) Still 6 out of 8 trades for 75% win rate a pretty ok day.

“Healthy Habits for a strong Equity Curve” Part 1

Looking at the two images above which one would you rather be over time? I think most would want the first :) The second image if that was a rocket being shot into space well “Houston I think we have a problem…” The second image as you can see is not going anywhere fast. This person if that was reflected over a period of so many months for both of them, the first guy slowly increased and grew the second guy went way up and way down and in the end the first guy keeps growing and continues on, the second at some point either gives up because he is not going anywhere or is institutionalized after a nervous breakdown from all the stress lol. Now how do you develop habits to create a smooth equity curve. This is where you become OBJECTIVE instead of SUBJECTIVE – You constantly monitor your trading results and stay focused on making them objective results that you can measure and plot out over time. I am going to stop here and continue in the days to come, because our brains are only able to compute so much data at a time and by spreading this out it will be far more effective to you over time even if you are not cognizant of this at first. So first think of what is being stated and in the future I will go over how to implement this into your daily routine so success becomes a habit for you. Until next time enjoy!

Equity Curve

An equity curve is a graphical representation of the change in the value of a trading account over a time period. An equity curve with a consistently positive slope typically indicates that the trading strategies of the account are profitable, while a negative slope shows that they are generating a negative return.

Breaking Down Equity Curve

Since it presents performance data in graphical form, an equity curve is ideal for providing a quick analysis of how a strategy has performed. Also, multiple equity curves can be used to assess various trading strategies performance and risk.

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Equity Curve Calculation

Assume a trader’s starting capital is $25,000 and his or her first trade of 100 shares had an entry price of $50 and an exit price of $75. Commission on the trade is $5

The trade is recorded in a spreadsheet as follows:

Starting capital = starting capital – ((entry price x qty of shares) – commission)

  • $25,000 – (($50 x 100) – $5)
  • $25,000 – ($5,000 – $5)
  • $25,000 – $4,995
  • $20,005

Starting capital = starting capital – ((exit price x qty of shares) – commission)

  • $20,005 + (($75 x 100) – $5)
  • $20,005 + ($7,500 – $5)
  • $20,005 + $7,495
  • $27,500

Repeat the above process for each new trade.

Trading the Equity Curve

All trading strategies produce an equity curve that has winning and losing periods. The visual representation is similar to a stock chart. Traders can apply a moving average, either simple or exponential, to their equity curve and use it as an indicator.

A simple rule could be introduced to stop the strategy trading if the equity curve falls below the moving average. Once the equity curve moves back above the moving average, the trader may want to start trading the strategy again. Trade automation software allows traders to backtest their strategy to see how it would have performed on historical data. This typically includes the ability to generate an equity curve for each strategy used.

Trading signal rules could be strengthened by adding another moving average to the equity curve and waiting for a crossover of the two lines before a decision is made to stop or start the strategy. For example, if the fast moving average crosses above the slow moving average, the trader would begin or recommence their strategy, and if the fast moving average crosses below the slow moving average, they would halt their strategy.

Equity Returns, Recessions, and the Yield Curve: The Most Insightful Thing Ever?

by FatTailed · Published September 10, 2020 · Updated September 30, 2020

This might be one of the more insightful things I’ve ever realized in my life, so I will try to describe it succinctly and simply:

The yield curve is an important predictor of equity performance in the intermediate term.

  1. The relationship between valuation and returns is extremely weak in the short term yet extremely strong in a 10 year time horizon.
  2. The spread on the 10 year to 2 year bond yield is a significant predictor of returns in the intermediate (3-5 years) timeframe.
  3. I propose the business cycle and the dynamic nature of recessions bridges the gap between short-run and long-run discrepancies.
  4. Current projected market returns based on valuations and the yield curve are poor.

Returns vs Valuation: The Shiller Effect

Robert Shiller won the 2020 Nobel Prize in economics for proving that valuation matters in long-run equity returns, so this concept is not new. He coined the concept of CAPE (cyclically adjusted price to earnings) to account for his measure of valuation, and showed that this metric was negatively correlated with future returns.

Rather than using CAPE, I use Warren Buffett’s alleged favorite indicator for market valuation, which is Total Market Cap / GDP. Throughout this article, I refer to it simply as the Buffett Indicator (BI). It illustrates the current price environment is rather pricey.

Over the last 30 years, a plot of 10 year forward equity returns with starting valuation clearly illustrates Shiller’s point. VALUATION MATTERS!

However, conducting the same approach on 1 year returns shows a very weak association between equity returns and beginning valuation, consistent with the work of Fama, Malkiel, and others. The proverbial ‘random walk’ suggests that markets are reasonably efficient in the short run and CANNOT BE PREDICTED.

The longer the investment horizon, the more the starting valuation impacts eventual returns. We cannot predict the moves day-to-day or even over the next couple of years of the stock market, but 90% of your future return in the decade-plus time frame is dictated by the price of earnings at entry point.

The Yield Curve Matters

Nothing so far is earth-shattering. However, this blog has been a big proponent of why the yield curve matters (post #1, post #2, post #3, post #4). So what IS somewhat new and insightful is:

The yield curve contains important, statistically relevant information to starting valuation in explaining intermediate term returns.

This can be seen graphically by plotting the percentage of the equity return explained by valuation and yield spread metrics over time:

This graph is amazingly important, so I want to be sure its meaning is captured.

#1 on the graph (the upward slope of the line) is the representation of Shiller’s Nobel Prize. Returns are pretty much impossible to predict in the short run, but over a 9-10 year period, valuation does quite a good job at explaining those returns. For 1 year returns, we predict about 10% of the market’s return with valuation whereas 85% of the returns are explained by valuation in the 10 year time frame.

#2 on the graph (the gap between red and black lines) is the realization from this article that in the intermediate time frame of 2-5 years, the yield curve spread is an important component of equity return. Between them, the yield spread and valuation explains over 50% of the 4 year annualized return. As the time frame lengthens to 8 or 9 years, the predictive power of the yield curve spread evaporates, and valuation is the key determinant. Full estimates of the regressions are at the bottom of the article.

Reconciling short-term vs long-term dynamics

Robert Shiller attributed the divide between short-run efficiency and long-run inefficiency to investor exuberance and sentiment. I believe there is certainly an element to that, but ultimately I believe it is the business cycle that collapses valuations, and my belief is the specific time of recessions cannot be forecast because they are themselves dynamic.

I think people become exuberant not because they are stupid, uneducated, or otherwise simply financially unsavvy, but because they think they have the secret sauce of figuring out when a recession will hit and that they will be able to exit equities before that time period. The difficulty of observing a recession in real time is discussed here for the 2000 recession.

To repeat, I don’t think people are stupid, but I think they think they are stupid enough to believe they will see a recession coming. However, recessions are stochastic events that CANNOT be seen coming.

  • The economy is an extremely dynamic and interrelated system, balancing millions of different markets with their own lead and lag times and adapting at different rates.
  • The economy is run and controlled by humans. Humans are subject to basic emotions of greed, fear, and a particularly nasty herd mentality.
  • Capital markets are too large of a part of life for individuals, companies, and governments to ignore. CEOs and families alike act differently when they have just watched their worth get blown up or interest rates spike by 200 bps.
  • Therefore, capital markets themselves are feeding into the decisions made that impact the real economy, while receiving and reacting themselves dynamically to the activity in the real economy. This can be seen in that interest rates clearly impact both equities and the real economy in a feedback loop.
  • But what ultimately causes a recession? Why does one specific bank failure tilt the wagon over when in another time and place things might be just fine?
  • The underlying decay of the economy (in debt loads, bad investment decisions, etc) reaches a point where it is extremely susceptible to a bank failure or a Fed rate hike. Perhaps it takes a mere 10 percent equity meltdown to set off a crisis. The herd starts to panic.
  • Projects are delayed, workers are gradually furloughed. The effect snowballs and is only seen in the economic data ex-post, much as we see with the fall 2000 and early 2001 data.
  • Therefore, the reason we observe a peak in the stock market 6 months before a recession is because the snowballing effect of equity sell-offs and loss of confidence is itself becoming a recession in a self-fulfilling prophecy. Economic data is only observable ex-post of the severity of the crisis.

Outlook: Its Not Great

I therefore view the yield curve as a wonderful indicator of how at risk the economy is. No one (not even the Fed) can be absolutely certain they will be able to spot a recession in real time, but the yield curve provides useful intelligence of the aggregate level of risk in the macroeconomy. I liken an inverted yield curve to counting cards and knowing the deck is stacked against you… it’s probably time to walk away from the table.

With that said, the projected ten year returns from this point are likely to be meager:

Importantly, the yield curve suggests intermediate term equity returns are also likely to be poor. While the model fit is much poorer than the 10Y, they are nevertheless suggestive of an economy which is late cycle and an equity market that is extremely expensive from a valuation perspective.

Please follow me at @fattailedhappy for more content like this.

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