Shake that ladder!
Say you have got a great system to trade. It could be a simple logic that is handwritten or it could be a complicated computer algorithm to dig Gold from the mines of the markets. Literally it could be anything; Technical, fundamental or quantitative. How well can you trust this system of yours? How can you be sure that the back-tested results (or even the real results) your system produces is a reliable estimate of the returns to come in the foreseeable future or is it just Lady luck shining upon your beatific face?
Enter Monte-Carlo Analysis:
In the same way as the last thing you do before climbing a ladder is to shake it, you can choose to do a Monte Carlo Analysis before entrusting your money with your trading system. The principle is simple: You take the various trades of your system and re-order them and compute the various trade statistics. The new positions of the trades will be determined randomly. The important thing to note is that every trade still exists like before — no trade is modified, deleted or added. This is the permutation method without replacement.
The final outcome of all the trades will still be the same, irrespective of the order of the trades. The different equity curves will only have different shapes and different drawdowns but all roads will still lead to Rome which will be the sum of all trades. The analysis will also give you the final results with a degree of confidence. This analysis (the number of times you randomly re-order the trades) should be done for a few thousand times to get a realistic picture of the system’s prowess. For illustration, assume 7000 permutations were done on a system and the following results came up:
The performed Monte Carlo Analysis tells you, with 99% confidence, that the worst case drawdown of your trading system will not exceed $22,341 and the average drawdowns will be in the range of $2600. Maybe you want to compare this figure with your average profit per year and take a decision. Whatever you do, do shake that ladder before you trade!
Originally published at https://www.linkedin.com.