The Flaw of Single-Sequence Backtests
If your strategy generated 60 wins and 40 losses over the past year, your backtest shows a single linear equity curve. However, what if 8 of those 40 losses occurred consecutively at the start of your trading journey? Monte Carlo simulation reshuffles trade outcomes thousands of times to model all possible distribution sequences.
The 95th Percentile Drawdown Rule:
If your backtest showed an 8% maximum drawdown, but Monte Carlo simulation reveals a 95th percentile drawdown of 22%, your risk model must be sized to survive a 22% drawdown without triggering account liquidation.
How to Run a Monte Carlo Trade Audit
Export your verified 100-trade execution history (entry, exit, R-multiple). Run a randomized bootstrap algorithm that selects trades with replacement across 10,000 iterations. This generates a comprehensive probability distribution of maximum drawdown, recovery time, and Sharpe ratio stability.
Practical Sizing Adjustments
- If your risk-of-ruin calculation exceeds 0.5%, immediately cut your risk per trade by 50% (e. G., from 2% down to 1%).
- Set portfolio stop-loss thresholds based on the 99th percentile Monte Carlo drawdown estimate.