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Fooled By Monte Carlo Analysis

Simple Monte Carlo analysis tools are often used to assess the risks of trading strategies and to determine appropriate capitalization levels. However, simple trade reshuffling algorithms can produce misleading results in many cases and fool their users.

There are several Monte Carlo analysis tools available to traders. Some of these tools are even distributed for free via popular forums and blogs. Although these tools can be useful in certain cases, they can also produce misleading results when the following conditions are true:

  1. Strategy is over-fitted on historical data and/or the win rate is too high
  2. There is forced long-short symmetry in trade generation
  3. Longer-term trend following
  4. Trades that depend on the outcome of certain other trades
  5. Trade generation uses equity curve feedback
  6. Strategy dynamics depend on position sizing
  7. The trade sample is very large
  8. The strategy is developed via data-mining

Basic Monte Carlo Method

Given a vector of n trade results (P/L):

T[0] = {T1, T2, T3, …,Tn}

then k new vectors may be generated by reshuffling the original trade results. There are now k+1 vectors of trade results and corresponding equity curves, which can be used to access the potential of the strategy, its risk, drawdown, etc.

Rationale and assumptions

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