Is Monte Carlo Analysis Useful?
Posted: Sun Mar 26, 2006 7:06 am
[MODERATOR'S NOTE: This topic was split from one in the Trading Blox Support Area discussing the new Monte Carlo feature in Trading Blox.]
Old European wrote:I first want to say that I'm convinced that c.f. (and sluggo) is doing a great job in implementing Monte Carlo in TBB. The graphs presented so far look really really nice.
I also think I understand why he is adding this Monte Carlo functionality: the system developers' marketplace asks for it and competing products allow also for MC testing.
I however have a fundamental theoretical problem with Monte Carlo and system testing.
As sluggo described very well above, it's all about looking at trading results in parallel universes. These universes can be created in two (or more) different ways. Or one randomizes the order in which trades are generated or one randomizes the daily (or ...) returns.
I am not convinced that this makes a lot of sense. While backtesting I always note that a lot of the time when I'm long USD against EUR I am also long USD against CHF ... when I'm short LC I am also short FC ... and so on. There are inter-market correlations. When one randomizes the trade order, one doesn't take these correlations into account and the newly created parallel universe has nothing to do with the real world.
The same thing applies to the randomization of daily returns. Again when backtesting I always observe that there are regularly periods of mostly positive daily returns. Why? Because there are strong trends in a number of markets and a market trends until it finally bends. When the daily returns are randomized, all of this gets lost and the newly create world is very ir-real.
Ideally one should only look at parallel universes and virtual market data time series that show similar correlations and trending behavior as the real world. These are however extremely difficult to construct.
Cheers,
Old European