A Brief Glimpse into Theoretical Physics

Last time I mentioned a concept arguably more suitable for a theoretical physics blog than a blog on option trading:

     > To say “calculate [drawdown] as if it happened on Day 1” is to
     > say any ordering of events is equally likely. A 2011-type
     > correction could have just as well happened in 2002 and a 9/11
     > could have just as well happened in 2008, etc.

Understanding our current reality as a cumulative result of historical events/decisions is a controversial interpretation amounting to fate and destiny. While many people do understand the world in these causal terms, cognitive psychology suggests the human brain works unconsciously to identify causation even where none actually exists. This is adaptive: living in a logical world is certainly less stressful than living in a world where utter chaos lurks around every corner.

How robust is our current reality? Is it like a sequence of dominoes where toppling of just one can affect everything that comes after? Is it more like Jenga where many previous decisions may be altered before the present is affected?

Trekkies will always remember the words of Jean-Luc Picard in “Yesterday’s Enterprise:” “Who is to say that this history is any less proper than the other?”

Another good description of the infinite realities concept is shown here from time index 07:00 to 09:45.

For all these reasons, I mentioned “overstated conclusion” in the final paragraph. I do not want to make the mistake of basing trading decisions on the shape of a backtested equity curve. People commonly ask to see these historical equity curves without realizing that these are just one possible path a trading system may follow through time. A slight alteration in the trade sequence may result in worse drawdowns, losing periods instead of profitable ones, etc.

Gaining that “broader perspective” by numerous Monte Carlo simulation runs can decrease the chance of falling prey to this sort of curve-fitting.