Self-study Plan for becoming a quantitative trader

Self-Study Plan for Becoming a Quantitative Trader - Part I | QuantStart

Nice Begin
BBeginner's Guide to Quantitative Trading | QuantStart

Quantitative trading is an extremely sophisticated area of quant finance. It can take a significant amount of time to gain the necessary knowledge to pass an interview or construct your own trading strategies. Not only that but it requires extensive programming expertise, at the very least in a language such as MATLAB, R or Python. However as the trading frequency of the strategy increases, the technological aspects become much more relevant. Thus being familiar with C/C++ will be of paramount importance.

A quantitative trading system consists of four major components:

• Strategy Identification - Finding a strategy, exploiting an edge and deciding on trading frequency
• Strategy Backtesting - Obtaining data, analysing strategy performance and removing biases
• Execution System - Linking to a brokerage, automating the trading and minimising transaction costs
• Risk Management - Optimal capital allocation, "bet size"/Kelly criterion and trading psychology

We'll begin by taking a look at how to identify a trading strategy.

Strategy Identification

You might question why individuals and firms are keen to discuss their profitable strategies, especially when they know that others "crowding the trade" may stop the strategy from working in the long term. The reason lies in the fact that they will not often discuss the exact parameters and tuning methods that they have carried out. 

Contrary to popular belief it is actually quite straightforward to find profitable strategies through various public sources. Academics regularly publish theoretical trading results (albeit mostly gross of transaction costs). Quantitative finance blogs will discuss strategies in detail. Trade journals will outline some of the strategies employed by funds.

These optimisations are the key to turning a relatively mediocre strategy into a highly profitable one. In fact, one of the best ways to create your own unique strategies is to find similar methods and then carry out your own optimisation procedure.

Here is a small list of places to begin looking for strategy ideas:

• Social Science Research Network - www.ssrn.com
• arXiv Quantitative Finance - arxiv.org/archive/q-fin
• Seeking Alpha - www.seekingalpha.com
• Elite Trader - www.elitetrader.com
• Nuclear Phynance - www.nuclearphynance.com
• Quantivity - quantivity.wordpress.com

Many of the strategies you will look at will fall into the categories of mean-reversion and trend-following/momentum.

A mean-reverting strategy is one that attempts to exploit the fact that a long-term mean on a "price series" (such as the spread between two correlated assets) exists and that short term deviations from this mean will eventually revert.

A momentum strategy attempts to exploit both investor psychology and big fund structure by "hitching a ride" on a market trend, which can gather momentum in one direction, and follow the trend until it reverses.

Another hugely important aspect of quantitative trading is the frequency of the trading strategy. Low frequency trading (LFT) generally refers to any strategy which holds assets longer than a trading day. Correspondingly, high frequency trading (HFT) generally refers to a strategy which holds assets intraday. Ultra-high frequency trading (UHFT) refers to strategies that hold assets on the order of seconds and milliseconds. As a retail practitioner HFT and UHFT are certainly possible, but only with detailed knowledge of the trading "technology stack" and order book dynamics. We won't discuss these aspects to any great extent in this introductory article.

Strategy Backtesting

The goal of backtesting is to provide evidence that the strategy identified via the above process is profitable when applied to both historical and out-of-sample data. 

It is perhaps the most subtle area of quantitative trading since it entails numerous biases, which must be carefully considered and eliminated as much as possible.

We will discuss the common types of bias including look-ahead bias, survivorship bias and optimisation bias (also known as "data-snooping" bias). Other areas of importance within backtesting include availability and cleanliness of historical data, factoring in realistic transaction costs and deciding upon a robust backtesting platform. We'll discuss transaction costs further in the Execution Systems section below.

 The traditional starting point for beginning quant traders (at least at the retail level) is to use the free data set from Yahoo Finance.

The main concerns with historical data include accuracy/cleanliness, survivorship bias and adjustment for corporate actions such as dividends and stock splits:

• Accuracy pertains to the overall quality of the data - whether it contains any errors. Errors can sometimes be easy to identify, such as with a spike filter, which will pick out incorrect "spikes" in time series data and correct for them. At other times they can be very difficult to spot. It is often necessary to have two or more providers and then check all of their data against each other.
• Survivorship bias is often a "feature" of free or cheap datasets. A dataset with survivorship bias means that it does not contain assets which are no longer trading. In the case of equities this means delisted/bankrupt stocks. This bias means that any stock trading strategy tested on such a dataset will likely perform better than in the "real world" as the historical "winners" have already been preselected.
• Corporate actions include "logistical" activities carried out by the company that usually cause a step-function change in the raw price, that should not be included in the calculation of returns of the price. Adjustments for dividends and stock splits are the common culprits. A process known as back adjustment is necessary to be carried out at each one of these actions. One must be very careful not to confuse a stock split with a true returns adjustment. Many a trader has been caught out by a corporate action!

When backtesting a system one must be able to quantify how well it is performing. The "industry standard" metrics for quantitative strategies are the maximum drawdown and the Sharpe Ratio. The maximum drawdown characterises the largest peak-to-trough drop in the account equity curve over a particular time period (usually annual). This is most often quoted as a percentage. LFT strategies will tend to have larger drawdowns than HFT strategies, due to a number of statistical factors. A historical backtest will show the past maximum drawdown, which is a good guide for the future drawdown performance of the strategy. The second measurement is the Sharpe Ratio, which is heuristically defined as the average of the excess returns divided by the standard deviation of those excess returns. Here, excess returns refers to the return of the strategy above a pre-determined benchmark, such as the S&P500 or a 3-month Treasury Bill. Note that annualised return is not a measure usually utilised, as it does not take into account the volatility of the strategy (unlike the Sharpe Ratio).

Once a strategy has been backtested and is deemed to be free of biases (in as much as that is possible!), with a good Sharpe and minimised drawdowns, it is time to build an execution system.

Execution Systems

The key considerations when creating an execution system are the interface to the brokerage经纪人佣金（或回扣）, minimisation of transaction costs (including commission, slippage and the spread) and divergence of performance of the live system from backtested performance.

As an anecdote, in the fund I used to be employed at, we had a 10 minute "trading loop" where we would download new market data every 10 minutes and then execute trades based on that information in the same time frame. This was using an optimised Python script. For anything approaching minute- or second-frequency data, I believe C/C++ would be more ideal.

In a larger fund it is often not the domain of the quant trader to optimise execution. However in smaller shops or HFT firms, the traders ARE the executors and so a much wider skillset is often desirable. Bear that in mind if you wish to be employed by a fund. Your programming skills will be as important, if not more so, than your statistics and econometrics talents!

 Depending upon the frequency of the strategy, you will need access to historical exchange data, which will include tick data for bid/ask prices. Entire teams of quants are dedicated to optimisation of execution in the larger funds, for these reasons. Consider the scenario where a fund needs to offload a substantial quantity of trades (of which the reasons to do so are many and varied!). By "dumping" so many shares onto the market, they will rapidly depress the price and may not obtain optimal execution. Hence algorithms which "drip feed" orders onto the market exist, although then the fund runs the risk of slippage. Further to that, other strategies "prey" on these necessities and can exploit the inefficiencies. This is the domain of fund structure arbitrage.

arbitrage the practice of buying sth (for example, shares or foreign money) in one place and selling it in another place where the price is higher 

The final major issue for execution systems concerns divergence of strategy performance from backtested performance. This can happen for a number of reasons. We've already discussed look-ahead bias and optimisation bias in depth, when considering backtests. However, some strategies do not make it easy to test for these biases prior to deployment. This occurs in HFT most predominantly. There may be bugs in the execution system as well as the trading strategy itself that do not show up on a backtest but DO show up in live trading. The market may have been subject to a regime change subsequent to the deployment of your strategy. New regulatory environments, changing investor sentiment and macroeconomic phenomena can all lead to divergences in how the market behaves and thus the profitability of your strategy.

 Risk Management

"Risk" includes all of the previous biases we have discussed. It includes technology risk, such as servers co-located at the exchange suddenly developing a hard disk malfunction. It includes brokerage risk, such as the broker becoming bankrupt (not as crazy as it sounds, given the recent scare with MF Global!). In short it covers nearly everything that could possibly interfere with the trading implementation, of which there are many sources. Whole books are devoted to risk management for quantitative strategies so I wont't attempt to elucidate on all possible sources of risk here.

Risk management also encompasses what is known as optimal capital allocation, which is a branch of portfolio theory. 

Another key component of risk management is in dealing with one's own psychological profile.A common bias is that of loss aversion where a losing position will not be closed out due to the pain of having to realise a loss. Another common bias is known as recency bias. This manifests itself when traders put too much emphasis on recent events and not on the longer term. Then of course there are the classic pair of emotional biases - fear and greed. These can often lead to under- or over-leveraging, which can cause blow-up (i.e. the account equity heading to zero or worse!) or reduced profits.