Saturday, February 28, 2009

Linear Equity Growth, Which one is Good, and Which one is NOT

Automated trading systems have several ways in which they increment the trader's equity (if that is the case). The way an equity curve looks like can give you a great deal of information about a system's profitability, in particular, it can give you a lot of information about the system's risk to reward ratio, the possibility of account wipe out and the general way in which the system trades and uses your money. The objective of this post is to show you different equity curves, in particular equity curves which grow linearly, so that you can see what you should and what you should not look for in a forex expert advisor.

In general, a linear equity curve is an equity curve which when regressed using statistical analysis returns a high correlation coefficient against the equation that represents a straight line. This does NOT necessarily mean that the equity curve is a straight line, it means that equity tends to grow in a geometrical fashion.

Linear Equity Curves - What NOT to look for

The most common equity curves you should find, and the ones that are most commonly attractive to forex traders new to the world of forex expert advisor and automated trading is the straight line linear equity curve. These equity curves consist of a straight line with no pitfalls or loses. This curves are very characteristic of systems with huge risk to reward ratios, progressive money management systems (such as martingales) and systems that never close losing open positions. The Robominer ea equity curve shown below is a very good example of this, see how it fits perfectly over the red line I drew.
Seeing no loses, is a BAD thing, loses are a vital part of a forex system and they always exist. When you see and equity curve with apparently no loses, it does not mean that the system does not lose, it just means that for some reason you are not seeing that. The next picture shows you a little bit how this works. The picture you see on your left is what is typically shown to the investor, an expert advisor that for some reason does not show any loses. With further testing, the ea shows loses, which generally overcome the winners by a lot. Sometimes a single loss in some systems with high risk to reward ratios can wipe out ten or more winners. So What you should be thinking when you see this equity curves is that you are NOT looking at the whole picture, you are being shown what they want you to see.

Linear Equity Curves - What to look for

So now that we know which types of equity curves are inherently either much likely unprofitable or deliberately hiding something about the automated trading system we now need to see the equity curves which are the mark of profitable expert advisor. What do we want to see ? First, we need to see a long period of testing, (nine years works best) and an expert advisor which is not prone to large back testing errors. We want an ea that is NOT a scalper.

Our idea is to see the whole picture, we want to see the expert's profits, loses and others and then see how equity grows in time amongst the very different market conditions that have happened in the past. A very good example of this is the last version of God's Gift I have been talking about which is adjusted to market volatility. As you can see, the equity curve can generally fit the description of a straight line (statistically) which means that equity growth is linear. However, as you can see, the expert does have loses, but loses are much smaller than profitable trades. What this shows us is that the ea is tackling a vital characteristic of the market which lets it profit amongst all the different market conditions during the past 9 years (back testing was done from Jan 2000 to Jan 2009 at 90% modeling quality). The expert does have loses, but profits are greater.
As you can see, the expert's testing has sections that would "look" like straight lines by themselves and have no loses, but if the expert is globally profitable then it is much more important to see the entire picture to get a real image of how much you can expect to get as profit against how much you are risking as expected draw down.

If you would like to learn more about the God's Gift expert advisor and other profitable free and commercial expert advisor please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !

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