Stop at the Equity Curve (20) (Part 1)

What happens when the equity curve is used as an indicator to be in or out?

To study this, I used my -0.10/3x spreadsheet with 3,798 trades. As an arbitrary starting point, I used a 20-SMA (current day included) to be calculated after the close. When necessary, I waited one whole trading day to take action.

What’s particular about this approach is the methodology by which I have simplified the equity calculations but logistics must be considered when transitioning to real-time application. The final gain/loss registered at trade close is added to the account at trade inception. This creates the appearance of more continuity in the spreadsheet than might actually be experienced.

Consider a big down day that pushes multiple trades to maximum loss. The spreadsheet shows the total equity and MA after each trade is tabulated but in reality they would all be closed at once. This could significantly reduce the efficacy of the risk-management tool. From a mark-to-market perspective, it is conceivable that cumulative losses on many trades might drive equity below its moving average before any single trade actually closes for max loss. I’m afraid the only way to compare the two would be to backtest again and track daily equity in this manner. Hopefully it will become clear after a small sample.

When I traded naked strangles, I anecdotally noted great potential savings were I to have exited positions after incurring the greatest daily loss over the last several weeks and staying out of the market entirely until I saw a weekly equity gain. This makes me think there might be something useful about monitoring EOD equity vs. the moving average but I also wonder if this might be accompanied by more whipsaws.

Aside from timing issues, another issue requiring careful consideration is the position neutralization itself. Slippage would be horrific if I tried to close an inventory of legs especially if I had to replace them a few days later. I might be better off creating a delta-neutral position by purchasing NTM options and holding until the equity curve crosses above once again.

Having said all this, I’ll run through the results in my next post.