What is the Monte Carlo Method in Forex?
Monte Carlo Simulation, also known as the Monte Carlo Method, is a computer simulation technique used to estimate the possible outcomes and in the case of a trader, estimate a strategy's viability.
The goal of our Monte Carlo tool is to help illustrate and predict the variability of your trading returns with confidence. The simulation is based upon your trading strategy metrics like:
Risk percent of balance per 1 trade
Ratio Take profit/Stop loss
Break even %
Average trades per month
Total number of months that strategy will trade
* This is an educational tool and results should not be construed as investment advice.
The metrics tell a story...
Explore the meaning behind the numbers
Monte Carlo helps Forex traders establish probabilities of a number of important performance metrics:
Risk of ruin
The probability that a trader will lose a certain percentage of their capital
The peak-to-trough decline of an investment during a specific period
Annual rates of return
The average yearly profit rate
Return / drawdown ratios
The average return in a given period of time
The answers are hiding in the past...
How does the Monte Carlo Simulation work?
In the most simplistic way, the Monte Carlo simulation works on the theory that the best estimate of your future performance is derived from your past trades.
So how can it predict possible outcomes based on your past trades? The law of large numbers theory. Ever heard of it? Think of a 2 sided coin. If you toss that coin 10 times your distribution of heads and tails outcome could be 8:2 (in favour of tails). Tossing this 10 times would be classed as 1 sample. Tossing the coin a further 10 more times would be sample 2. Can we expect 8 tails and 2 heads again? Perhaps, although the distribution might be 6 heads and 4 tails in this sample.
What's important to understand here is that playing the coin toss game 1 million times, the distribution will be far closer to 50/50 (heads/tails) than what we find in a smaller "sample".
Playing the coin toss game 1 million times, the distribution will be far closer to 50/50 (heads/tails) than what we find in a smaller "sample".
When we trade our first 10 trades might not produce the outcome we expect to see over 1,000 trades. But as traders it's important we understand the behaviour and characteristics of what our strategy can produce in terms of wins / losses.
This way we can stay true to our rules despite going through a period of drawdown (negative returns). Therefore reducing the chance of trading emotionally, which is the last thing we want to do as traders!
In addition to the benefits of building confidence, you'll also begin to view trading like a professional, whereby you see it as a game of statistics. Past performance is not indicative of future returns. Future return distribution can vary yet still conform to the trading strategy metrics in the past.
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