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An equity curve is a graph showing the value of a trading account over time. In its simplest form it shows the overall trend in the success of the trader and the trader's strategy. It can also be used to keep track of how much money a trader has available to move to different investments, remembering to take account of margin requirements.
The production of an equity curve is an extremely simple process. The x-axis represents the total value of a selected set of investments, most commonly everything a person currently has invested. An alternative selection would be all the investments a person has made using a specific technique or system; this would allow comparison of multiple systems. The y-axis represents time, commonly with a figure for the end of each day's trading.
Analyzing an equity curve can be as simple as checking the overall direction of movement: a curve moving upwards is a sign of investment assets rising in value. Some traders will also look at the shape of the curve rather than just its direction. A smooth upwards curve will suggest a consistently balanced and successful approach. A curve that is moving upwards overall, but is very jagged and moves up and down may suggest the positive results may be more the result of luck than judgment and can indicate an unnecessarily risky strategy.
The equity curve can also be used for exploring other aspects of investing than simply overall profitability. For example, an investor might look back at a chart showing the value of the trading account over the past six months. Instead of simply looking at the overall trend or the final position, she could look to find the lowest value that the account reached.
This is significant as many traders borrow money to invest, known as margin trading. If the investments fall in value, the trader may be required to put up more cash to protect against failing to repay the loan. Analyzing the equity curve in this way might reveal that a strategy that appears to be successful overall might not be practical to use in the future as it requires too much available cash from the trader.
There is a significant limitation to the equity curve. It only shows the changes in the value of the investments and does not usually take account of when the trader actually decided to sell the relevant assets and cash in. This means it lacks insight into a key part of investing: not just choosing the right investments, but selling at the right time. Indeed, a steep upwards equity curve may appear to be a great sign, but it could also indicate the overall value is gaining from an unsustainable peak or bubble and is at risk of suddenly dropping. This could mean the investment strategy may not be as successful as it appears.
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