QF206 Week 1. Quantitative Trading Strategies. Introduction. 1 of 46 January 7, Christopher Ting

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1 Quantitative Trading Strategies Introduction 1 of 46 January 7, 2017

2 What is Quantitative Trading? Also known as algorithmic trading Trading based on buy-or-sell signals generated by algorithms, which are implemented on computer systems for automated executions Algorithmic signals are highly data driven. Macroeconomic news: non-farm payroll, FOMC policy etc. Fundamentals: revenue, cash flow, earnings-per-share etc. Technical: Moving averages, stochastic indicator, etc. High-frequency: state of the limit-order book Algorithmic executions are highly technology driven. 2 of 46 January 7, 2017

3 The Gist of Quantitative Trading As long as you can represent relevant information into bits and bytes that the computer system can operate on by the algorithms, it can be regarded as a part of quantitative trading. Technical analysis Fundamentals News 3 of 46 January 7, 2017

4 In a Nutshell Algorithmic trading refers to procedural trading rules or strategies From technical analysis to complex neural network strategies. Trading horizon can be intraday (high frequency) or longer Based on trading signals to Open a position Close a position, either to take profit or stop loss 4 of 46 January 7, 2017

5 Institutional Algorithmic Trading (1) Algorithmic trading (also called automated trading, black box trading and robo-trading) is used to break up large orders into smaller orders to reduce execution risk preserve anonymity, minimize the price impact of a trade. Hidden portions of large institutional orders are sometimes referred to as dark liquidity pools. Orders are often partially revealed, in which case they are called iceberg or hidden-size orders. 5 of 46 January 7, 2017

6 Institutional Algorithmic Trading (2) The use of programs and computers to generate and execute orders in markets with electronic access. Orders come from institutional investors, hedge funds and trading desks. Institutional clients need to trade large amounts of stocks. These amounts are often larger than what the market can absorb without impacting the price. The main objective of institutional algo trading is not necessarily to maximize profits but rather to control execution costs and market risk. The demand for a large amount of liquidity will typically affect the cost of the trade in a negative fashion (slippage). Large orders need to be split into smaller orders, to be executed electronically over the course of minutes, hours and days. 6 of 46 January 7, 2017

7 Institutional Algo Strategies Algorithmic trading results from mathematical models that analyze quotes and trades, identify liquidity opportunities, and use the information to make intelligent trading decisions so as to Trade at or better than the average price over a day (e.g. VWAP, volume weighted average price) Execute optimally so as to have minimal price impact. Trade more at market opens and closes when volume is high, and less during slower periods such as around lunch. Exploit arbitrage opportunities or price spreads between correlated securities. 7 of 46 January 7, 2017

8 Algo Trading in General Algorithmic trading is also used in a more general sense to include Alpha Models used to make trading decisions to generate trading profits or control risk. Thus, more generally, algorithmic trading can be defined as trading based on the use of computer programs and sophisticated trading analytics to execute orders according to pre-defined strategies. 8 of 46 January 7, 2017

9 Who Can Be a Retail Quant Trader? It is true that most institutional quant traders have advanced degrees in mathematics, science, and engineering. But trading is deceptively simple: Buy low sell high Sell high buy low The crux of the matter is to consistently achieve profitability (after costs, taxes, etc.) quarter after quarter. If you have taken a few courses in math, statistics, and programming, you are probably as qualified as anyone to tackle some of the basic statistical arbitrage strategies. 9 of 46 January 7, 2017

10 Who Cannot Be a Retail Quant Trader? No savings to take care of family commitments Need immediate profits to sustain daily living No discipline Crave for adrenalin pumps Exuberate over-confidence bordering hubris in character Hope, delay, and then cut losses in despair Blame others for losses Addicted to trading! No emotional intelligence Extreme greed: too much risk Extreme fear: too risk averse No capacity to conduct independent research 10 of 46 January 7, 2017

11 Major Asset Classes Tradable Instruments 11 of 46 January 7, 2017

12 What to Trade? Stock Rights ES Futures ADR REIT ETF Gold USD/SGD Fixed Income Options Structured Warrant 12 of 46 January 7, 2017

13 Four Major Asset Classes and Derivatives Funds Forward and futures Options Stocks or equities Currencies or forex Commodities Fixed income instruments underlying asset 13 of 46 January 7, 2017

14 Four Major Asset Classes and Derivatives Derivative Markets Cash Markets 14 of 46 January 7, 2017

15 With versus Without Maturity Stocks, currencies, and commodities are asset classes that have no maturity. Derivatives and fixed income instruments have maturities. For a plain vanilla security with maturity, it is possible to compute its fair price. The fair price constitutes a reference price for trading futures and options. 15 of 46 January 7, 2017

16 Linear Price-Profit Plot Profit S T K 0 K price of underlying at maturity, S T K S T 16 of 46 January 7, 2017

17 P-P Plot: Nonlinear Payoffs of Options K = Strike price, S T = Price of asset Long a call Payoff Payoff Short a call K K S T S T Payoff Long a put Payoff Short a put K S T K S T 17 of 46 January 7, 2017

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22 Copper, High Grade: Comex Spot Price $ per lb Source: WSJ 22 of 46 January 7, 2017

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24 Observations Every asset class has its own price dynamics. In fact, at the market microstructure level, every tradable product exhibits a different market behavior just like no two people are 100% alike, even for twins Example: Nikkei futures So, which product to trade? 24 of 46 January 7, 2017

25 Cash Market versus Derivative Market Cash index Singapore MSCI Index Nikkei 225 Index Futures contracts SIMSCI futures contracts Nikkei futures Spot rates EUR/USD GBP/USD Futures contracts EUR-USD USD-JPY 25 of 46 January 7, 2017

26 When to Trade? Big news like non-farm payroll will cause short-term wild swing When market opens and closes, short-term swings tend to happen Ever heard of quadruple witching? Sell in May and go away, is it true? End-of-year tends to be more quiet. The keywords are, Seasonality, Episodes 26 of 46 January 7, 2017

27 Regulated exchanges Where to Trade? Dark pools Self-regulatory Brokered market Over-the-counter (OTC) market 27 of 46 January 7, 2017

28 Controversies Controversy 1: It is a zero-sum game. Controversy 2: Market is efficient in impounding information into prices. Controversy 3: Big (HFT) player has an unfair advantage. Controversy 4: MARKET is a gigantic Casino. Money And Return Keep Everybody Trading 28 of 46 January 7, 2017

29 Why Trade? In the face of these controversies, why trade? To invest To divest To rebalance the portfolio To conduct market timing To encourage entrepreneurship, capital market is needed. But have we been brainwashed by capitalism? To hedge against price fluctuation To manage risks To make a living!? Scalping Market making 29 of 46 January 7, 2017

30 How to Trade? This course is mainly about how to trade, and also how not to trade. Trading strategies, plans, discipline, realistic expectations, common sense are needed 30 of 46 January 7, 2017

31 Who trade? Seek, test, implement Why trade? What to trade? Where to trade? When to trade? How to trade? + Hobby + Extra $ + Bring home the bacon + Alternative + Bond + Commodity + Derivative + Equity + FX + SGX + Eurex + CME + Market opening + Market closing + How many units per trade? + How to set the entry and exit points? 31 of 46 January 7, 2017

32 Trading versus Investment 32 of 46 January 7, 2017

33 Value versus Price Image Source: ``It is not a case of choosing those that, to the best of one s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees. 33 of 46 January 7, 2017

34 Experiment Pick a number between 1 to 12 you think is the month of birth of instructor s son. Pick a number between 1 to 12 you think the majority will pick. 34 of 46 January 7, 2017

35 Trading versus Investment Trading focuses more on short-term profit and loss (P&L) P&L = selling price buying price Investment focuses more on medium- to long-term return Return selling price - buying price buying price 35 of 46 January 7, 2017

36 A Numerical Illustration Suppose you sold 3 contracts of SIMSCI and closed your position within the same The P&L would be, per contract, = 0.50 index point, which is 10 ticks. For SIMSCI futures, each index point is S$100. Therefore, the total profit before costs is S$100 = S$150. Suppose your equity, the fund deposited at your broker, is $30,000. The return on equity (ROE) of this trade is 0.5%. 36 of 46 January 7, 2017

37 Source: Algorithmic trading and DMA 37 of 46 January 7, 2017

38 Major Types of Buy-side Stock Investors Institutional investors Mutual fund Passive exchange trade fund (ETF) Pension fund Sovereign wealth fund Hedge fund Insurance company Bank Corporate nominee Retail Start-up investor Family business Household/individual 38 of 46 January 7, 2017

39 Types of Traders Who is at the other side of my trade? Source: Trading and Exchanges: Market Microstructure for Practitioners 39 of 46 January 7, 2017

40 Treachery Thin Lines Investors are lured into the speculative mode. Often times, profitseeking speculative traders are lured into the gambling mode 40 of 46 January 7, 2017

41 Market Making Dealers constantly buy and sell in the market. Post quotes and stand ready to trade, and thereby provide immediacy and liquidity to the market. Market makers need capital to finance their inventories. The capital available to them thus limits their ability to offer liquidity. Because market making is very risky, investors generally do not like to invest in market-making operations. Market-making firms that have significant external financing typically have excellent risk-management systems that prevent their dealers from generating large losses. 41 of 46 January 7, 2017

42 Scalping Dealers often are known by other names. At futures exchanges, dealers are often called scalpers, day traders, locals, or market makers. At many stock exchanges and options exchanges, they are known as designated market makers instead. Scalpers are dealers who buy and sell for their own account. They try not to hold large positions for more than a few minutes. They are continuously acquiring and unwinding their positions. 42 of 46 January 7, 2017

43 Trading Strategy 1: Scalping Intra-day indicators as buy/sell signal from charts Market making Picking up nickels in front of a steamroller 43 of 46 January 7, 2017

44 Portfolio Rebalancing As time goes on, a portfolio's current asset allocation will drift away from an investor's original target asset allocation. If left unadjusted, the portfolio will either become too risky, or too conservative. The goal of rebalancing is to move the current asset allocation back in line to the originally planned asset allocation. In portfolio rebalancing, investors need to trade large quantity, and a liquid market is beneficial. 44 of 46 January 7, 2017

45 Market Timing The act of attempting to predict the future direction of the market, typically through the use of technical indicators or economic data. The practice of switching among mutual fund asset classes in an attempt to profit from the changes in their market outlook. Example: Allocate more into bond market if equity risk increases Many hedge funds and active mutual funds are trying to beat the market. But on average, their performances are dismal, as academicians would want you to think. 45 of 46 January 7, 2017

46 Takeaways Algorithmic/Quantitative trading is about using data, machine learning (Artificial Intelligence), and automation to trade. Seek and test algo trading strategies using the art and science of statistics to determine what, where, when, and how to trade. Every listed tradable is unique. Trading is not about you and other market participants. Remember Keynes beauty contest metaphor. Scalpers provides liquidity. 46 of 46 January 7, 2017