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# Monte Carlo Simulation

Discussion in 'Technical Analysis' started by WAWTU31, Nov 30, 2005.

1. ### WAWTU31

Can anyone shed any light on how I might begin to learn how to use this method of Financial Engineering.

2. ### sabotage

Monte Carlo simulation as a tool sounds more elaborate than what it really is. That is not to say that you cannot use it for elaborate analysis.

You need to determine what you need to figure out. For instance, what is the probability of a coin flipping head or tails. Create a process that acts like a coin: for instance a binary random variable in an excel sheet, that returns 0 or 1, with a 50% chance each. Generate the variable 10000 times and count how many times you get 1 and 0. You result will tend to 50%.

You can price an option using Monte Carlo simulation. This time, however, generate a Brownian motion price path with a given volatility. Run it many times and see what your option is worth on expiry and discount. The outcome should quickly converge to the Black and Scholes value.

3. ### horribilicus

Amazon dot com sells a book called "Monte Carlo methods in finance" and another one called "Monte Carlo simulation in finance." Maybe they might be of some benefit.

It's not a method of financial engineering, it's a physics method. People in economics and finance haven't invented anything...

5. ### Champion

In practical terms how you would apply the Monto Carlo simulation to the price path of index futures or an index such as the Dow? Cheers.

Pssst...don't tell anybody else, but there is an explicit formula for all the options you'll be able to trade as a retail trader....

7. ### WAWTU31

Thank you for your response...is there a website where I can download info into Excel or code writing for dummies?

8. ### WAWTU31

generate a Brownian motion price path with a given volatility

Would you be so kind to provide an example of how to do this I am seriously interested.

9. ### cakulev

I have also a question.
Lot of people talk of backtesting in conjunction with MC simulations. I understand the value of Monte Carlo in option pricing, I understand (somewhat) the value in backtesting, but this is what puzzles me:
When you have trading method that exploits non-randomness when simulating do you:

a) Generate price path based on some neutral distribution, e.g. lognormal
b) You include the non-randomness in the distribution

If a how can you have positive results?
If b isnât that a sell-fulfilling prophecy?

Many thanks.

10. ### squeeze

People that are back-testing systems use MC to get a more representative idea of profit and max drawdown.

This is a simple process of just drawing trades from the trade sample set generated in the back test. It is not the same idea as MC applied to option pricing.

#10     Dec 1, 2005
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