Monte Carlo Simulation uses the historic returns of your trading strategy to generate scenarios for future strategy returns. It provides a visual approach to volatility and can overcome limitations of other statistical methods.
Monte Carlo Simulation
Monte Carlo is the synonymous for a random process like the numbers picked by a roulette wheel.
The Monte Carlo Simulation does the same to your historic strategy returns. It re-arranges them in a random manner to generate new outcomes for your trading strategy. Using this approach significant properties of the original returns are kept. e.g. p/l of trades, duration of trades, flat periods, outliner trades… Classic statistics like standard deviation sometimes have problems capturing these properties, thus leading to wrong results like underestimating the future volatility of returns.
Using Monte Carlo equity projection will offer new hints on the strategies volatility and return expectations.
Monte Carlo Simulation uses the historic returns to generate equity projections; e.g. instead of your historic returns of +5, -1, +6, -3, +2 Monte Carlo could lead to a series of 2, -3, -1, +5, +6. Both would have the same absolute win, but different statistical properties. Series 2 has a higher total drawdown than your original returns, a hint that you just have been lucky in the past and might want to prepare for higher volatility in the future.
Monte Carlo simulation of strategy returns
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