What Is A Good Equity Curve? – Profit & Loss Curves Best Practices and Analysis

If you have come so far in your trading that you rely on backtesting to validate your trading strategies, you definitely are ahead of the masses. Most people haven’t understood that all strategies and patterns they want to trade need to be validated before they may go ahead and risk any real money. However, while validating a strategy by assessing the equity curve might seem like an easy task, there are quite some things you need to know not to get lured by the results. So, what is a good equity curve?

A good equity curve is one that has an even slope, small and short-lived drawdowns, and a good amount of trades to make the observation statistically significant. It’s also important that the profit and loss aren’t impeccably smooth, since one that appears like a perfectly drawn line indicates that the underlying trading system is curve fit, and unlikely to perform well going forward.

In this guide to equity curves, we’re going to look at how you should assess the profit & loss curves that your systems produce, and what they tell you about the strategy. Although the appearance of the curve on its own doesn’t predict the probability of the strategy working in the future, it tells us a lot of important information about the strategy. It is simply a great tool that shouldn’t be overlooked.

Let’s begin!

(Before we go on, we’d like to mention that we have a backtesting course that covers all aspects of how to backtest.)

The Metrics We Use To Assess Equity Curves and Strategies

You could use an endless amount of trading metrics when evaluating equity curves and strategies, and we understand that it might be hard to know which ones to focus on. In addition to the common ones like profit factor, average trade, and other similar metrics, you have advanced mathematical ratios and formulas that, according to us, are given more attention than they deserve.

Here are the most important metrics, according to us:

Profit factor

The profit factor of the trading system is a critical metric. The profit factor is a metric that takes the aggregate profits of a system divided by the aggregate losses. For instance, if the system made $2000 in profits, and lost $1000, you would have a profit factor of 2.

In our strategies, we want to have a profit factor of at least 1.75 depending on the type of strategy we’re dealing with. In breakout strategies, 1,5 might be on the lower end, but still fully acceptable, if the other metrics of the strategy look okay.

However, in mean reversion strategies we demand a higher profit factor of at least 2, depending on the circumstances.

Keep in mind that the more restrictive you are about the trades you take, the higher the profit factor tends to become. Similarly, the more you loosen your criteria, the lower the profit factor tends to be.

Average Trade

It’s essential to ensure that the strategy has an average trade that is enough to cover commissions and slippage and leave some of the profits for you. As we’ll cover in a bit, too many people forget this step and subsequently build trading strategies that are losing strategies once transactional costs have been applied.

The evenness of the curve

The more even the PnL curve is, the better. It simply shows that the strategy has managed quite well in all the varying market conditions that arose during the testing period, and makes you more confident that it will work well going forward.

This means that you want flat periods to be as short-lived as possible and that the c