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Behind the Scenes: The Monte Carlo Simulation

The Monte Carlo Simulation (MCS) is a method of computational analysis employed by our Business Development team to ascertain how a given strategy is likely to perform in a range of different situations.

  • What is it? A statistical technique used to model complicated systems (with complex interactions of many variables) and establish the odds for a variety of outcomes. Used by professionals in various fields incl. finance. Method translates uncertainties in model inputs into uncertainties in model output (results).
  • Origin. Created by two mathematicians von Neumann and Ulam. The method was devised after WWII to simulate behaviour of atomic weapon. Named after Casino where Ulam’s uncle gambled.
  • How it works. Uses random inputs to model the system and produce probable outcomes. Given a range of values for each variable, a MCS will randomly select a number within each range, and note the result – and repeat the process millions of times. When the simulation is complete with a large number of results from the model; results are used to describe the probability of reaching various results. No two iterations in the simulation might be identical, but collectively they build up a realistic picture.
  • Random values are generated with a specified distribution. Opportunity to end the test when the distribution of all values within a parameter list is normal. Simulations are as good as their inputs.

Benefits of MCS

  • Probabilistic results. Showing outcome and likelihood based on the input ranges of estimates.
  • Graphical results. MCS data displayed as graphs of outcomes and chances of occurrences.
  • Sensitivity analysisto see which input variable has the biggest impact on results.
  • Scenario analysiswith combination of different input values to estimate results.
  • Correlation of inputs analysis. To understand interdependency between input variables.
  • Use of random numbershas the additional advantage of avoiding unfair targeting of values that may be known in advance to perform well.

MCS applied to Forex (example and benefits)

  • Use back-testsresults to gain information about how good or bad a trading system is.
  • When used to simulate trading, the trade distribution (represented by the historical list of trades) is sampled to generate a trade sequence. Thousands of different sequences of trades are randomised and analysed. Rate of return and drawdown are calculated and a probability is assigned to each result.
  • Construct sequence of trades by random samplingwith or without replacement.
  • Risk simulator. Helpful in estimating likely rate of returns, drawdowns, risk of ruin, etc.
  • Stress testing systems. Get estimate of worst possible outcomes/ behaviour of our systems, worst consecutive losing runs, worst drawdown