Introduction to Quantitative Finance

Quantitative Strategies
Week 8

traders.berkeley.edu
Announcements

● Coding HW 2 due on March 23 (next Thursday night)

● Max Dama in-person guest lecture from Headlands next week!
○ Maker of the Quant Trading decal 2010-2011 (around 15 people!)
○ Extremely informative, it will be very fun
○ Mandatory: Read his PDF prior to lecture (Google “Max Dama PDF”)
○ A legend in the quant industry
● Decal social?? Show of hands
tinyurl.com/pre-att-1
 Question of the Day
Imagine you have a stock, where the price will go up by $1 with 50% probability and
down by $1 with 50% probability each day.
Your lecturer Prakash came up with the following sick strat (“Kash Money TM”): Each day
if the stock price rises, buy 1 stock, if the stock price drops, sell one stock.

In the end, you clear out your position (sell off all stocks, buy back all shorted positions)
at whatever price the stock ends up at.

What’s the distribution of your PnL? You don’t need to give the parameters of the
distribution.
 Question of the Day Hint
Say you’ve got a buy on day k, then that buy contributes +1 for every buy - sell
for all the days before it.

Similarly, it contributes (total buys after day k minus total sells after day k) to the
total pnl.

The opposite is true for sells.

At this point, can you write an equation for the total PnL?

- Let’s say there a b buys and s sells in total.

 Question of the Day Solution
The total PnL is buys * (buys-sells-1) + sells * (sells-buys-1)

● -1 because we don’t want to account for today (the day of the buy or sell).

Statistics beyond this point:

Buys and sells are both Binomial(n, 0.5)

buys * (buys-sells-1) + sells * (sells-buys-1) = buys^2 - buys - sells = buys^2 -

(buys + sells) = buys^2 - n

Binomial(n, 0.5) ≈ Normal using CLT, so buys^2 - n ~ Chi-squared

 Agenda
1. Options follow-up: delta hedging
2. Arbitrage
3. Pairs Trading
4. Overview of Trading Strategies
5. Review of Basis Arb
 APLS - Apellis Pharmaceuticals
●Currently trades at $62 a share
●FDA phase 3 trials result coming in a day
●If positive (60% chance), stock will go to $70
●If negative (40% chance), stock will go to $50
 What trade(s) do we make?
$70
0 %
6
$62
40
%

$50
today tomorrow
 What trade(s) do we make?
$70 ●None!
0 %
6 ●Expected value of tomorrow’s price is
(0.4)*50+(0.6)*70 = $62
$62 ●Means stock is fairly priced –we expect to
make $0 (on average)
40
%

$50
today tomorrow
 What trade(s) do we make?
$70
0 % ●None!
6
$62
40
%

$50
today tomorrow
What actually happened?
 When would we have made a trade?
●If the market was mispricing the stock
 When would we have made a trade?
●If the market was mispricing the stock
●Ex: stock currently trading at $64,
all else same
 What trade(s) do we make?
$70
60%
$64
40
%

$50
today tomorrow
 What trade(s) do we make?
$70
60% ●Let’s short the stock!
●What happens on average tomorrow?
$64
●(0.6)*(-6) + (0.4)*(14) = +$2 profit
40
%

$50
today tomorrow
 What trade(s) do we make?
$70
60% ●Let’s short the stock!
●What happens on average tomorrow?
$64
●(0.6)*(-6) + (0.4)*(14) = +$2 profit
●This is only expected profit – not
40

real profit!
%

$50
today tomorrow
 What can we do?
●We see a $2 expected profit opportunity in the market.
Is there a way we can “lock in” our expected profits?
 What can we do?
●We see a $2 expected profit opportunity in the market.
Is there a way we can “lock in” our expected profits?

●How do the pros do it?

What can we do?

●We see a $2 expected profit opportunity in the

market.
Is there a way we can “lock in” our expected profits?
●How do the pros do it?

●Options can be great here.

 Re-intro to options
●Call option
○Right, not obligation, to buy a stock later at a
pre-specified “strike price” (for our purposes
$62)
●Put option
○Right, not obligation, to sell a stock later at a
pre-specified “strike price” (for our purposes
$62)
Re-intro to options

●Options are contracts.

●You must purchase
options to get their
powers (right to
buy/sell at a
pre-specified price)
Fair price of the call option
●Stock is going to either $70 (60% chance)
or $50 (40% chance)
 Fair price of the call option
●Stock is going to either $70 (60% chance) or $50 (40% chance)

●If we have the option to buy (or not buy at all) at $62 (strike
price),
○ Buy it when it goes to $70 for $62 – making +$8
○ Not buy it when it goes to $50 – making $0
 Fair price of the call option: $4.80
●Stock is going to either $70 (60% chance) or $50 (40% chance)

●If we have the option to buy (or not buy at all) at $62 (strike
price),
○ Exercise option (buy stock for $62) when it goes to $70 – making +$8
○ Not exercise at $62 when it goes to $50 – making $0

●Call is worth (0.6)*8 + (0.4)*0 = $4.80

 Fair price of the put option: $4.80
●Stock is going to either $70 (60% chance) or $50 (40% chance)

●If we have the option to sell (or not sell at all) at $62 (strike price),
○ Not exercise at $62 when it goes to $70 – making $0
○ Exercise it (sell it for $62) when it goes to $50 – making +$12

●Put is worth (0.6)*0 + (0.4)*12 = $4.80

So how can we use options?
We wanna make money no matter what
happens (FDA results + or –)
 Hedging
●Short stock, buy $62-strike call
 Hedging
●Short ONE stock, buy TWO $62-strike calls
○60% chance of (+) news:
■Payoff = (–$70 + $64) + (2*$8 – 2*$4.80) = $0.40
○40% chance of (–) news:
■Payoff = (–$50 + $64) + (– 2*$4.80) = $4.40
●The one/two are not quite right – perfect hedge ratio is called the
delta of the option
 Perfect Hedging
●Short 1 stock, buy 2.5 $62-strike calls
○60% chance of (+) news:
■Payoff = – $70 + $64 + 2.5*$8 – 2.5*$4.80 = $2
○40% chance of (–) news:
■Payoff = – $50 + $64– 2.5*$4.80 = $2

$2 of riskless profit no matter what

Arbitrage
 “Pure” Arbitrage
● “Risk-free” profit
● Buy low, sell high simultaneously

● If I offered you a dollar every day, would you take it?

● Muddled definition

● Further reading: Ch. 17, Trading and Exchanges Markets and Microstructure
Real Life Arbitrage

Buy @ 220 → Sell @ 400

arbitrageur
 Exchange Arbitrage

● Common in crypto!
 Basis Arb
● ES, SPY
○ ES is 50x S&P index and SPY is 0.1x S&P Index

ES SPY
Bid / Ask
3200 / 3220 3190 / 3199 Bid Size x Ask Size
50 x 50 4000 x 4000

How do you arb this?

SPY ES

2910 / 2930 2901 / 2909

2300 x 3000 26 x 11
Crude Oil + Refined Oil = Oil

Bid / Ask
Bid Size x Ask Size
Crude Oil Refined Oil Oil

65 / 66 49 / 50 117 / 118
11 x 11 10 x 12 1 x 100
 Foreign Exchange Example
0.70 USD / SGD, 0.64 AUD / USD, 1.11 SGD / AUD

What’s the arb? You have a $1,000? What’s your PnL?

 Delivery Arbitrage
Spot oil trades at -$20. The month is April 2020. Oil futures trade at $10 in
August 2020. It costs $0.01/day to hold a barrel of oil. What’s the arb?

Assume 30 days in a month.

Citadel owns ships for doing this

 Options Arbitrage
Buy call, sell put = Stock Price - difference in cash (Stock Price - Strike Price)

(Assume 0% interest)

AAPL trades 140.

130 Z (Dec) Call trades $10.12.

130 Z (Dec) Put trades $0.14.

Arb!
 Merger Arbitrage
Elon said he’s taking TWTR private for $54.20.

Elon whispered in your ear he’s secured funding and has sent the paperwork over.
The deal is going through!

TWTR trades $42.06996024. What do you do?

 (Some) Arbitrage Risks
● Transaction cost risk

● Basis risk

● Holding/time risk

● Slow convergence

Arbitrage is rarely truly risk-free!

“Pure” arbitrage is usually structural. We’ll also discuss statistical arbitrage.

Pairs Trading
 Fundamental (Pure Arb) Pairs Trading
Buy and sell two assets that are structurally, fundamentally, or statistically
arbitrageable.
Structural:
● ES trades lower than SPY, buy 1 ES, sell 500 SPY
Fundamental:
● Brent vs Western Texas Oil
● GOOG vs GOOGL
Statistical:
● Coca-cola vs Pepsi, Visa vs Mastercard, Ford vs GM
 Statistical Pairs Trading
● Stationarity and cointegration, not
just correlations!

● Returns, not price series!

● Some additional readings:

https://quantdare.com/correlation-p
rices-returns/

https://thehedgefundjournal.com/c
orrelation-is-not-always-what-it-se
ems/
Trading Strategies
(Quick note)
 Categories of Strategies
● Basis arbitrage (recap)
○ ETF arbitrage
○ Foreign exchange arbitrage
● Options market making / trading (previous lectures)
● Statistical arbitrage (briefly today)
● HFT trading (later)
● Rates (fixed income), commodities, credit arbitrage / trading etc.

These are some of the major prop/quant trading strategies.

Strategies don’t exist in silos! Strategies are combinations of these.

This is also only one interpretation of how to categorize strategies.

 Basis Arbitrage
Profiting off the difference in the basis (points) between two equivalent securities.

● ES, SPY
● S&P Basket vs SPY
● Korean ETF vs Korean stocks
● LME Oil (UK) vs CME Oil (US)
● …

Naive games exist for the fastest players.

Huge basis arb game is ETF arb

ETF Arbitrage
● NAV: Net Asset Value

● ETF - NAV > 0: creation

○ Short ETF, Long NAV

● NAV - ETF > 0: redemption

○ Short NAV, Long ETF

● Major players
Foreign Exchange (Forex) Arbitrage
Triangular arbitrage

● EURGBP

● → GBPUSD

● → EURUSD = 1.5

Major players
 How do I make my trading strat better than yours?
Develop an “edge”. This is what you’ll be doing.

● Every firm has the same basic strat.

Good risk-taking / sizing. Key for ETF arb.

Client relationships
Speed, smarts (alpha)

(this is a joke)
Statistical Arbitrage
 Recall Pairs Trading
Coca-cola and Pepsi, Apple and Google, Visa and Mastercard should move
together.

Can I build a trading firm out of just this strategy? What issues might arise?

● Too easy!
● Doesn’t happen very often.
● Limited capital deployment
 Let’s Breakdown Pairs Trading
Visa is trading cheaper than Mastercard. Buy Visa, sell Mastercard.

What did we do?

Reward: Captured an alpha / edge / return / profit. Bought relatively lower (with
intention to sell higher).

Risk: Reduced our risk by selling a similar asset.

Let’s quantify this!

 Quantifying Pairs Trading
Maximize reward. Let’s create some sort
Reduce risk = exposure to credit card
of score.
companies
Visa is cheap (good). Score = 1
Visa Beta = 1, Mastercard Beta = 0.9
Mastercard is expensive (bad). Score =
-0.1.
Our Trade
Buy Visa, sell Mastercard. Score = 0.9, Beta to Risk = 0.1.
What if we only bought Visa? Score = 1, Beta to Risk = 1.

Maximize reward relative to risk (Sharpe ratio).

 Expanding Pairs Trading to Statistical Arbitrage
Rather than trading two assets against each other (pairs trading), trade a basket of
assets against each other.

Addressing our previous concerns:

● Too easy!
● Doesn’t happen very often.
● Limited capital deployment
 Statistical Arbitrage Optimization Problem
Given a set of n assets, maximize reward (score) subject to constraints on a set of
risks.

Steps:

1. Select assets.
2. Calculate exposure to each pre-determined risk for each asset.
3. Calculate score/reward for each asset.
4. Optimize -> optimized portfolio
5. Execute trades.
6. Repeat (usually every market open).
 Statistical Arbitrage Example
Asset Optimization Reward Risk 1 (Beta 1) Risk 2 (Beta 2)
Name Decision (Score)

Asset 1 Buy 1 1 1 1

Asset 2 Sell 1 -0.2 2 1

Asset 3 Buy 1 -0.3 1 0

Asset 4 Sell 1 -2 0.4 5

Asset 5 Buy 1 0 0.2 5.2

Total Optimized Portfolio 2.9 0.2 0.2

 How do I win the Statistical Arbitrage game?
Data
● Inputs to reward and risk model

Smarts
● Reward model
● Risk model. Barra model.
● Optimization

Execution

Frequency of trading
 Questions?
https://tinyurl.com/qdlec8