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Monday, June 24, 2024

Monte Carlo Simulation in Backtesting: Why All Traders Need It

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When you’re testing trading strategies to gauge their profit potential, backtesting is a crucial step.

But it’s not enough to just stop at the total return of a strategy in backtesting.

There are many metrics that should be studied to assess the viability of a strategy, and if it will meet your goals.

A Monte Carlo simulation is a mathematical technique that can be used to stress test a trading strategy. It runs backtesting results through hundreds, or even thousands of possible scenarios, which helps traders uncover weaknesses and potential issues. 

I’ve found Monte Carlo simulations very useful and in this article, I’ll show you how they work, how to do a simulation and how to use the data from a simulation to make trading decisions.

Fundamentals of Monte Carlo Simulations

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Trading computer

Here’s a little historical background and key elements to how simulations work.

They will help you understand the value of them and how to use them in your backtesting process.

Historical Overview

There is a lot of debate over who created this method and how long ago it was developed.

Some historians believe that similar methods were used as far back as ancient Babylon.

When you think about it, this process is pretty common sense.

So it would make sense that it’s been in use for a long time, not just in the modern era.

However, the name “Monte Carlo Simulation” looks like it was developed during the 1940s, named after the famous Monte Carlo Casino in Monaco due to its elements of chance and randomness.

Statistical Principles

At its core, Monte Carlo Simulation relies on the Law of Large Numbers.

You leverage this by generating a large volume of random samples to represent a statistical distribution.

The theory is that the results converge on the expected value as the number of simulations increases.

It assumes that:

  • Actual outcomes can generally be determined by the probability achieved through many simulations
  • Statistical properties (such as mean and variance) are known
  • The Probability Density Functions (PDFs) adequately represent underlying conditions

Algorithmic Components

Implementing a Monte Carlo Simulation involves the following steps:

  1. Define a domain: Identify the possible inputs that affect your model. When using a simulation with backtesting data, the domain will be the actual backtesting trades.
  2. Generate inputs randomly: Create random variables that mimic the behavior of real-world data. In backtesting, the random variable is usually the order in which the trades are executed. But other variables can be used like the overall win percentage and randomly skipping trades.
  3. Compute simulation: Run the simulation model using these inputs to produce a result.
  4. Aggregate results: Perform the simulation multiple times to create a distribution of possible outcomes. With the help of a computer program, you can run a simulation thousands of times to zero in on the most probably result.

By employing these components, Monte Carlo Simulation can provide insightful data on the risk and uncertainties of your financial models, which is critical for robust backtesting.

Application in Backtesting

Monte Carlo Simulation is a powerful tool for backtesting trading strategies, allowing you to understand the potential risks and rewards by simulating various market conditions.

Establishing Parameters

First, you need to define the variables that will affect your trading strategy.

These include the initial capital, position sizing, stop-loss levels, and profit targets.

By setting these parameters, Monte Carlo Simulation helps you test the strategy against a range of outcomes to gauge its effectiveness.

Modeling Market Scenarios

Next, you’ll generate many hypothetical market scenarios using historical price data.

This step involves randomizing trade order and considering the volatility/correlation between different instruments.

You can then apply your trading strategy to these simulated scenarios to measure its performance under various hypothetical market conditions.

Risk Assessment and Management

Finally, the simulation provides a distribution of potential returns, helping you assess the risk associated with your strategy.

This is where you’ll examine key metrics such as:

  • Maximum Drawdown: The largest peak-to-trough drop in your portfolio’s value.
  • Value at Risk (VaR): The potential loss in value of a portfolio over a defined period for a given confidence interval.
  • Probability of Profit/Loss: The likelihood your strategy will result in a gain or a loss.

These insights enable you to refine your strategy, improve risk management practices, and adjust your expectations to align with the simulated realities of the strategy.

How to Do a Monte Carlo Simulation After Backtesting

As I mentioned earlier, software makes it easy to run simulations.

First, backtest your trading strategy.

This could be an automated or manual backtest.

Next, tell the simulation software to do X number of simulations, based on your actual backtesting trades.

I usually use 1,000 simulations, but you can use more or less, depending on your goals.

There are many software platforms that can do this, but I use NakedMarkets.

It strikes a good balance between ease-of-use and giving me useful information.

I simply tell the software the parameters of the tests and this is the report that it generates.

Click on the chart to see the screenshot in another tab.

Monte Carlo example

As you can see, I can randomize skipped positions, slippage and the order of my trades.

Skipping random trades is a good way to account for trades that you’ll miss because you’re away from the computer, on vacation, etc.

The fact that all of the simulations above show a very similar result is a good sign.

But that’s just the tip of the iceberg when it comes to analysis.

Analyzing Simulation Results

After completing a Monte Carlo simulation, you are presented with a wealth of data.

It’s critical to analyze this information methodically to determine the effectiveness of your strategy.

Equity Curves

First, look at your equity curves.

Consistently upward trending curves indicate a potentially successful strategy.

As seen above, it’s a good sign if the simulations are very similar.

If the results are very different, then that’s probably a risky strategy because the outcome is less reliable.

Performance Metrics

To quantify your strategy’s potential, focus on specific metrics:

  • Expected Return: Calculate the average of simulation outcomes to gauge the expected performance.
  • Maximum Drawdown: Look at the maximum drawdown across all simulations. This will give you an idea of your worst case scenario.
  • Average Win vs Average Loss: This is very important. Are your winners making up for your losers? This metric will tell you and also show you how much you can expect to profit.

By using these metrics, you can create a fact-based understanding of your strategy’s strengths and weaknesses.

Best Practices and Limitations

Backtesting on laptop

Applying Monte Carlo simulation in backtesting offers valuable insights into financial models.

But it requires careful implementation and acknowledgment of its constraints to ensure effectiveness.

Ensuring Model Accuracy

To enhance the accuracy of your Monte Carlo simulation in backtesting, you need to input high-quality data.

Data quality is paramount as it directly influences the simulation’s reliability.

Make sure to get clean data and get it from the source, whenever possible.

This means getting it directly from the exchange or broker.

A trusted third party data provider is also a good source for data.

Next, employ cross-validation techniques to test the robustness of your model.

This involves dividing your data into an optimization set and a validation set to prevent overfitting.

Backtesting on data that was not used in the optimization process will help you understand how well the strategy might handle unforeseen circumstances.

Common Pitfalls

One of the pitfalls in using Monte Carlo simulation is underestimating the role of market anomalies, which can skew results.

Be wary of overfitting, a model that performs exceptionally well on historical data may not necessarily predict future scenarios accurately due to its complex nature.

Also double check that your trading strategy has been implemented consistently.

If you changed your strategy in the middle of a test, your results will not be an accurate representation of your strategy and will be very likely to fail.

Finally, check that you’re properly accounting for expenses like commissions, fees, spread, swap and slippage.

Advanced Simulation Techniques

As computational power increases, you can improve your Monte Carlo simulation techniques by integrating machine learning algorithms to detect complex patterns in data.

Experimenting with parallel computing can significantly speed up simulations, allowing for a broader range of scenarios and increased iterations for more comprehensive backtesting.

Remember that Monte Carlo Simulation is a powerful yet fallible tool, and your results are subject to the validity of your assumptions and the scope of your data.

Stay informed about the latest advancements in simulation techniques to keep your backtesting robust and informative.

Conclusion

Adding a Monte Carlo Simulation protocol to your backtesting process is an easy way to get a grasp on how risky your trading strategies are.

Since backtesting will only ever give you one result per market and timeframe, randomizing your trades with a Monte Carlo Simulation will effectively give you hundreds, or even thousands of backtesting sessions, with the same trading strategy and the same historical data.

This will allow you to see how much variance there is between each simulation and what  your maximum drawdown could be, in a worst case scenario.

You can also do Monte Carlo Simulations on your live trading results.

It’s a very powerful tool that should be in the toolbox of every trader.  

 





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