Figure 7.2 equity curve crosses under a trendline, indicating it is time to reduce trades.

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direction. By connecting a series of significant lows, we have an uptrend line. By connecting a series of significant highs, we have a downtrend line. If you can draw an uptrend line, your equity is rising and your trading is going well. A break of the uptrend line can signal a start of losing trades. Figure 7-2 has an uptrending equity where an uptrend line can be drawn. Eventually, a series of losing trades causes the equity to drop below the trendline. This would be a good time to suspend trading to preserve capital. When your equity breaks below an uptrend line this could represent an area to reduce your trading. You can even just paper-trade your signals until the equity rises to form another uptrend line. A break below a trendline can signal the start of a losing streak. Drawing trendlines is more of an art that an exact science.

If you are unable to draw a trendline, perhaps the results of the trading are choppy, you should analyze the reasons why. If the system you have been following shows a terrible downtrending equity, you might be tempted to throw out the system. You might consider still following the system and drawing a downtrend line. If the equity breaks the trendline going upward, this could signify a good area to start taking signals. Maybe there was a good reason that the system and systems equity had fallen such as low volatility, or a choppy market. When the equity rises and breaks a downtrend line, the reasons for the system performing poorly could have changed.

Moving Average

A simple moving average taken of the equity line can provide some valuable insight. A trader can suspend trading or lighten up on position size when equity is

below the moving average. I recommend withdrawing to the sidelines completely when the equity line is below its moving average and simply continue tracking or paper-trading the systems trades. When the equity goes above the moving average, trading should resume. This technique ensures capital preservation, in case the system never returns to profitability (i.e., an equity line that goes to zero).

Furthermore, use a moving average that is slow enough so the equity line is not constantly crossing the moving average. Make sure it is not too slow, or a series of big losses will need to occur for the equity to fall below the moving average. A moving average length of 10 to 25 days is usually sufficient (see Figure 7.3). In addition, experiment with different moving averages to find the one that works best for you. Keep in mind that there are about a half dozen different moving averages. Each one is a little different than the next. Some have less lag, some weight present data heavier than older data, and others adapt to the market environment. Some include a volatility component. Experiment to find one that works well. My studies show that a simple moving average seems to work the best.

Stop and Start Trading with Equity

The logic behind Start and Stop Trading is simple. If a system is performing poorly and experiencing losses, equity will start to fall. As equity falls, it will eventually cross below its own moving average. When this happens, why not just simply stop

Figure 7.3 Comparing an uptrend line to an appropriately smooth moving average of the equity curve.

STARTING EQUITY

trading? Continue paper-trading and following the signals until the equity rises above the moving average and then start trading again (see Figure 7.4). The drawback is that you will miss the profitable trade that brought the equity above the moving average. Another drawback occurs if the results are choppy-a good profitable trade that brought the equity above the moving average could be followed by a losing trade. In this scenario, if you take the second trade (since the equity would then be above the moving average), that trade is a loss.

In the following example, I used a volatility trading system provided through Investograph Plus software. The market being used is the Standard & Poors 100 (OEX) from 12/31/91 to 5/20/92. The system uses an eight-day time frame and a 20 percent volatility factor for the breakout. Commissions used were $61 and every one-point move in the index will represent $266. The initial starting capital is $10,000. Initial results are shown in the Table 7.1.

Figure 7-5 shows the equity together with a 10-day simple moving average of the equity line. The following results occur if we stop trading when the equity is below the moving average. Figure 7.6 has the periods marked where the equity is below the average. Results are in the "Modified System" column of Table 7.1. Figure 7-7 shows the new equity curve with the new results. A much smoother equity curve resulted.

Figure 7.4 Short and stop trading. Trading is suspended when equity falls below the trendline and resumes when equity crosses above the trendline.

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