What to do with crazy Equity Curves…?

Below is a quote I pulled of the TradeStation Forum from the same individual, Joe Joseph, that posted the webinar in the previous post.

Performing this exercise as intended with one year of live trading data and a hypothetical starting account size of $1,000,000 (for simple numbers) we get the following result:

It turns out that an account that starts with $32,000 and risks 31% on each trade makes almost twice as much as an account starting at $1,000,000 which risks 2% on each trade. An account starting at $75,000 risking 14% on each trade makes just as much as the $1,000,000 at 2% account. And this is just after one year.

Further, after two years, the smaller accounts start winning at the $250,000 at 4% level and the margin of victory grows dramatically for smaller, more aggressive accounts.

The specific numbers are not terribly relevant, but what is illustrated is that if you break your account into small chunks and trade each of those chunks more aggressively, you will actually make more money once enough time has passed.

What’s even more remarkable is that the risk to initial capital is actually lowered at the same time. As an example, the maximum possible drawdown on initial capital for the 4% case is 25%, whereas for the full $1,000,000 account traded at 2% the maximum possible drawdown is 100%.

Even better than this, a trader who chooses to risk the entire 1,000,000 account and is unfortunate enough to fail loses her ability to fund another system with this capital, whereas the trader who broke her $1m account into four $250,000 pieces and traded one of those pieces at a time with 4% has four opportunities to succeed.

There is more to be learned here, but this should provide a good start.

At first what seems to be a brilliant insight is simply mean-variance optimization. A financial adviser will suggest you make an allocation into a “risky” asset (stocks) as well as a “riskless” asset (CDs, Bonds). The net effect of this diversification is a larger absolute return over investing 100% in stocks or 100% in bonds.

However in strategy development, this methodology can offer some interesting alternatives. We no longer have to dismiss erratic equity curves offhand. Say we develop a strategy with fantastic absolute return but relatively large draw down; We can easily cut DD percentage in half by doubling the initial capital, right? Some might say that’s cheating! Well is it? Your primary goal at the end of some arbitrary period is to have more money then you started without losing a lot of sleep. Compare the various scenarios and find out if it is in fact true. Here’s one idea, place 90% of your capital in T-Bills and utilize the remaining 10% to buy/sell speculative options. Using this thought process we now have a use for some of this equity curves we would have dismissed previously.


~ by largecaptrader on November 11, 2009.

One Response to “What to do with crazy Equity Curves…?”

  1. […] Equity Curves Continued Continuation of this post, I also found a toy model on the forum where you can play around with position sizing and portfolio […]

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