If you’ve ever had the electricity go out in your house and had to go to the garage to turn it all back on again, you know what a circuit breaker is. Wikipedia says, “A circuit breaker is a manually or automatically operated electrical switch designed to protect an electrical circuit from damage caused by overload or short circuit. Its basic function is to detect a fault condition and interrupt current flow.”
Interrupt the current flow are the words I would like to talk about. The current flow is your equity curve, the money coming into your account and the money leaving. Hopefully, this curve is moving upward but it will always move upwards in ebbs and tides.
Unfortunately, it is very hard to know if one of the ebbs, the drawdowns, is more than a normal drawdown and is out of the ordinary flow?
One question all traders ask themselves (or at least should ask themselves) is, “How do you know when its time to Interrupt the Current Flow, step aside and just watch?”
Well, there are many ways to do this, called system health, but one of the easiest and most visual is a moving average on your equity curve.
If your account balance falls below this moving average its time to move to cash and just watch.
Here is how Howard Bandy explains it on his blog. “The calculation begins with a trading system. Call this the “base” system.
“Use of the equity curve is done in two steps:
- Keep track of all of the trades that are signaled, and the equity curve produced by these trades. Call these the “shadow” trades and the “shadow” equity curve.
- Apply some technical analysis technique to the shadow equity curve as if that is a price series. When the results of “trading” the equity curve are good, take the signals generated by the base system. When they are poor, remain flat.
“Trading the equity curve is essentially the same as trading a price series. Apply any indicator you want to the daily equity. The equity curve is defined to be “good” when it is above its moving average, and “poor” when below. When it is good, signals from the basic system are passed through; when it is poor, all signals are blocked.”
QiT applies a moving average to each portfolios equity curve. Since the equity curves are different for each portfolio, the MAs we use differ as well. The MA will change as the equity curve changes, as well.
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