Ron Wichgers, an Atlas Line trader and trading instructor from the Netherlands, recently shared with us his thoughts on analyzing trading system performance. Using the Atlas Line data from our recent trades page from Jan. 1, 2013 through May 31, 2013, he’s created the graph below. Based on his professional trading experience, he’s also provided us with the following commentary.
The blue-grey line represents the performance of trading the Atlas Line from 9:30 a.m. to noon US/Eastern without broker transaction cost or slippage (using data from the Recent Trades page).
The red-pink line is the same as the blue-grey line only with my broker transaction costs added in.
The orange line represents the moving average (50) of the equity curve with transaction cost.
The bottom green-blue line represents the outcome per trade.
The Importance of Record Keeping
Whether you trade your own system, follow a signal service, or purchased a system like the Atlas Line, the first thing a trader needs to do is build a good track record trading that particular system. Good record keeping is not just to show how good your trading is. Good record keeping can help determine the strengths and weaknesses of a system.
To trade with confidence, you need to see how your system has performed in the past. However, this is not a guarantee for future results; it’s the best we have. When you plot the outcome of your trading in a graph, you can see system’s characteristics. These observations can help gauge reliability and boost your confidence in the system.
Every trading system, no matter how good it is, has it’s drawdowns. To plot an equity curve, you need to know how big the historical drawdowns are, how long the recovery period is when climbing out of the drawdown, and how frequent drawdowns occur. This is very important because we need this knowledge to trade with confidence in the future. Otherwise, you will give up trading when the first drawdown appears. Then you may be inclined to hop to another system where the same cycle of “drawdown, time to switch” starts again. That’s a guarantee for disaster.
The benefit of an equity curve is that you can easily see when your system’s performance differs from its “normal behavior.” When you come to an point that you have abnormal behavior like a drawdown that is much bigger or longer compared to what has happened in the past, this could be a warning sign to maybe reevaluate your system and at least slow down your position size for a while. Of course, this is not the best way to climb out of a drawdown, but it may prevent you from trading a system that is losing money. Maybe your system is not made for the current market conditions and you better wait for normalization of the market. In this example, consider the market conditions may be either too volatile or too slow for your trading system.
Another benefit of an equity curve is that you can easily see when the time is right to trade an extra contract. The equity curve you see in the picture uses one contract. That’s a good base to start with. When you have made a certain amount of money, you can add a contract and also plot the outcome with that extra contract in a different sheet, etc. Trading with multiple contracts is a way to give your trading an extra boost. When considering drawdowns, profits, broker commissions, and number of contracts traded, determining proper money management is of great benefit.
When do you add an extra contract? Of course, this is a very personal financial decision and it depends on the size of your trading account and your system’s performance. To determine when you add an extra contract, look at your equity curve. To stay in the “safe zone”, you must have made at least twice the size of the maximum historical drawdown. Why is this important? Well, to make the step from one contract to two contracts, that is a 100% scale up. In effect, if you end up in a drawdown right after you have scaled up, you may be in trouble because you also have to scale down again if you are back on the level where you have scaled up. You better try to avoid this situation.
You can easily calculate when you have to scale back down to one contract, but it’s better not to have to scale down too fast. It’s very easy to dig a hole with a giant scoop, but it’s a hell of a job to fill that hole again using a small one. Remember that each time you may scale up, percentage-wise, the steps become smaller.
How can you tell if an equity curve is the “safe zone”? I do plot a moving average of the equity curve. When this moving average is pointing down, that’s a warning sign for me.