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Would it not be true that the MC simulation, due to the high number of trade
sequences it generates, would come up with many sequences of trades which
contain unrealistically long sequences of losers, and therefore overstate
the system's max drawdown? Wouldn't it be better to look at the system's
losing percentage and average losing trade and use statistics to estimate
the probability of a particular level of drawdown?
-----Original Message-----
From: alex@xxxxxxxxxxxxxx [mailto:alex@xxxxxxxxxxxxxx]
Sent: Monday, July 15, 2002 12:18 PM
To: elliotdeane@xxxxxxxxx
Cc: omega-list@xxxxxxxxxx
Subject: Re: Limited life span of mechanical systems?
Elliot wrote:
>I would be interested to know what you consider the
>"Proper" method for employing MC analysis.
You didn't address this to me, but I tried to answer it yesterday.
I'll try again. The answer has nothing to do with equity curve
filtering; that's a whole 'nuther topic, one which I don't think is
all that useful to pursue.
>In my view, any analysis that ignores the time-serial
>nature of trading system returns is of limited
>utility.
Limited utility is better than none. As Dennis said, it's another
arrow in your quiver.
In my view, Monte Carlo simulation is useful for getting an idea of
the best and worst your strategy can throw at you, given that you
have a statistically significant collection of trades that represent
the performance of your strategy.
I use it for evaluating position sizing strategies. What happens
when I risk 4.5% of my equity on every trade? The original sequence
of trades says I'll earn 30%/year on my equity, with an 18% max
drawdown. That bit of information is well and good, but it doesn't
give me the whole story.
So I do a MC simulation. (I'm making these numbers up.) Now I see
that for several hundred different sequences of the same trades, the
average earnings is 32%/year with an average of a 29% drawdown seen.
The smallest max drawdown any trial had was 17%, the largest was
65%, with a standard deviation of 8%. I defined "ruin" as losing
60%, and 5% of the simulations ended up in ruin.
This analysis tells me whether the original sequence of trades is
representative of what I can expect if a similar set of trades
having a similar expectation occurred in another sequence.
What I do now is adjust the position sizing strategy to maximize my
MC return/drawdown ratio while not allowing the average max drawdown
to exceed some threshold of pain like 25%.
Once I do that, then I go back to the original sequence with the new
optimum position sizing strategy, and apply it.
Often, I find if I do this analysis on the original sequence ONLY,
it turns out not to be conservative enough in a MC simulation. The
MC simulation gives me confidence in the strategy's performance no
matter what order the trades come in. You just don't have that
confidence analyzing the original sequence only.
--
,|___ Alex Matulich -- alex@xxxxxxxxxxxxxx
// +__> Director of Research and Development
// \
// __) Unicorn Research Corporation -- http://unicorn.us.com
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