DEFINITION of ‘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. (For further reading, see: Interpreting a Strategy Performance Report.)
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 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
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
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. (To learn more about backtesting, see: Backtesting: Interpreting the Past.)
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.