Using Monte Carlo simulations in trading: Key assumptions

If you have read my blog for a while you may already be aware that one of the methods that I use for the evaluation of trading system failure involves performing Monte Carlo simulations. This type of simulation has several advantages over other methods, for example that you can derive a worst case boundary for practically any statistic you can obtain from a system equity curve and that you can evaluate these statistics online as a drawdown period evolves. You can read this post or this post for more information on how to perform these simulations using the qqpat library. However today we’re not going to talk about the practical aspects of these simulations but about the key assumptions that the simulations make about the strategies being used. If your trading system or setup violates any of these assumptions then it cannot be simulated efficiently using a normal Monte Carlo simulation and more elaborate or different methods are required.

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Let’s talk about the fundamentals of a Monte Carlo simulation first, so that we can understand its inherent limitations. A Monte Carlo simulation attempts to generate different possible equity curves coming from the same distribution of returns. The idea is that your system has a fundamental distribution of returns and you can gauge the probability that your strategy faces a given scenario by looking at the frequency of that scenario within the newly generated curves. If you’re facing a 10 month drawdown with a depth of 10% you can see how often this happens in the Monte Carlo simulation. If it happens 50% of the time then you know this is perfectly normal, if it happens only 0.001% of the time then you may want to start doubting whether your system is actually behaving according to the distribution you have used as a base (the fundamental distribution of returns).

The first obvious assumption of a Monte Carlo simulation is that the base distribution you’re using is a good proxy of the fundamental character of the strategy being traded. This means that the distribution is derived from a long enough sample as to be considered relevant given the changes you expect your strategy to go through in terms of market conditions. For this reason it does not make any sense to perform a Monte Carlo simulation using just 1 year of returns – no matter how many trades you have during this time, see this post – if anything you need at least 15-30 years to have a distribution that is somewhat representative of what you would expect. The first requirement for a Monte Carlo simulation is therefore a long enough back-test, perform it with a small sample and your systems will appear to fail very quickly, this is simply a reflection of you failing to capture the fundamental process underlying the strategy.

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The second and less obvious assumption comes from the way in which Monte Carlo simulations sample from the return distribution. These simulations generally sample returns randomly and therefore do not care what the last return is when drawing the next return. This makes the fundamental assumption of a complete lack of serial correlation in your returns. If your returns are serially correlated then Monte Carlo simulations do not make any sense. This may happen if you use techniques such as pyramiding where a winning or losing position immediately correlates to several other positions since the opening of trades is chained by the training logic and so is their outcome. In general any trading technique that either changes money management as a function of past losses or profits  or in which the opening of positions is done according to the outcomes of previous trades is in essence not suitable for Monte Carlo simulations. Most dangerously the risk for such strategies is usually underestimated greatly by the simulations since they lack the additional risk elements that come from an introduced auto-correlation within the return series.

Another important assumption may relate to how you exactly sample when you perform the simulations. In the case of qq-pat the library samples the daily returns of the trading strategy. If a strategy trades more than once per day then this assumption introduces an assumption about how trades are grouped each day, something that is not realistic for systems with daily trading frequencies higher than one. The reason why we did things this way was because it’s computationally far more efficient than drawing per-trade returns and avoids the introduction of an additional problem dealing with the time between trades – which happens when you try to do trade based MC simulations – however this assumption instantly makes the simulation of things like system portfolios inaccurate since these implementations by nature trade more than once per day and making draws from daily returns in such cases leads to inaccurate conclusions.

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Another critical assumption in Monte Carlo simulations is convergence of the tested statistic. When you perform a Monte Carlo simulation you’re interested in creating a distribution for a statistic you will be evaluating against in live trading and therefore the distribution must not change after a given number of iterations in the Monte Carlo simulation. This means that the evolution of the variation in the distribution of the statistic of interest should follow a logarithmic function where the variation asymptotically approaches zero as a function of the number of iterations. When you use a statistic the Monte Carlo simulation assumes that this state is reachable and that it will be reached before useful conclusions can be obtained. Use a very ill behaved statistic or too little iterations and you will get results that are inaccurate and may lead you to take wrong actions. The best solution in this case is to simply evaluate your statistic as a function of the number of iterations and check that the variation in the failure statistic does tend to zero as the number of iterations increases.

As you can see some of the above requirements are mandatory – convergence and a solid base distribution – but others can be circumvented provided that the simulations are custom modified to match them. For example the above does not mean that portfolios and serially auto-correlated strategies cannot be accurately simulated within Monte Carlo simulations but it does point out that these simulations require something far more customized than your vanilla simulator can provide. Simulating something like a pyramiding system requires trade-by-trade simulations where the serial correlation is explicitly introduced within the simulation process. Of course if you would like to learn more about system failure detection, Monte Carlo simulations and how to perform these analysis on your trading systems please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading.

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2 Responses to “Using Monte Carlo simulations in trading: Key assumptions”

  1. adam says:

    Hi Daniel,

    Is scaling – still a function of past losses or profits as in money management – not an obstacle for using MC?

    Cheers,
    Adam

    • admin says:

      Hi Adam,

      Thanks for writing. I do not understand very well what you mean by scaling. If you mean that your trades are always a percentage of the account then that’s no problem because the simulation is done in terms of returns. The important thing however is that your trades are not dependent on each other in terms of the percentage risked (that your percentage risk does not involve previous trade results). Do let me know if you have other questions,

      Best Regards,

      Daniel

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