10/3/24, 4:08 PM A Primer on Quant Strategies - Blueshift® Docs

A Primer on Quantitative Strategy

Development

Some definitions

Systematic Trading : Trading decisions in a methodical way

defining trading goals, risk controls and rules

Quantitative Trading : Trading signal generation based on

quantitative analysis

Algorithmic Trading : Execution of trades using automated

pre-programmed trading instructions

Hi-Frequency Trading : Algorithmic trading characterized by

high speed, high turn-over rates and high order-to-trade
ratios

What is a trading strategy

Strategy : A set of rules or a well-defined algorithm to choose an
action from the set of all possible actions in any state of a game.

Trading Strategy : Strategy (above). The game is stochastic (state

transitions are probabilistic), massively multi-player and potentially
long running.

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From a practical point of view, a trading strategy is nothing but an

algorithm that takes in as input a set of data (like asset prices, state
of the economy, fundamental ratios etc.) that captures the relevant
subset of the current state of the world, and generates a series of
orders.

The strategy spectrum

Trading strategies are diverse. But one way to look at it is from the
point of view of trading style and the underlying factor that guides
the profit or loss of the strategy. See below:

Here we capture the trading styles in the vertical axis and the profit
driver on the horizontal axis. Different styles try to capture the same
underlying driver in different manner. For example, value investing
for a fundamental investor, or swing trading of a technical trader or
statistical arbitrage of a quant trader - all focus on the same
underlying driver - mean reversion . For the value investors, it is
deviation from the fair price . For technical traders it is from the

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technical levels or support and resistance . For quant traders it

is from the modeled behaviour of relative price of two assets.

If you look closely, you will notice that almost all strategies can be
adapted for a systematic approach.

Fundamental vs quant trading

Tale of two styles

Let's understand the difference between fundamental vs.

quantitative approach of investing through an example:

Asset manager A is a discretionary manager and follows 10 stocks

diligently. Asset manager B is a systematic manager and has
enough computational power to track 500 stocks. Investors seek
outperformance and certainty.

Question #1 : What is the hit ratio for A to achieve

outperformance in at least 50% (total 5 stocks) of his portfolio
with at least 95% probability?

Question #2 : What is the hit ratio for B to achieve

outperformance in at least 50% (total 250 stocks) of his portfolio
with at least 95% probability?

Solution: Let the success rate (or hit ratio ) be p. Total required
success n, total trial N . Probability of n success out of N trials
follows the binomial distribution:

P r(n|N, p) = N Cn . pn . (1 − p)N−n

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Probability of at least n success (n = 5 for A, n = 250 for B):

n
P = 1 − ∑ P r(i|N, p)
i=0

We need to solve for p for A and B, such that P is 0.95 in both

cases. The result, once plotted, looks like below:

We see that the asking skill level or hit ratio for B is much
lower than A. B has to be right only around 55% of times, whereas
for A, the accuracy needs to be more than 80% - which is no mean
feat! This brings us to the most important concept of investment -
the fundamental principle.

Fundamental law of active management

The fundamental law of active management states 1:

IR = IC. √N. T C

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Information Ratio (IR) : Measure of success – risk adjusted

returns over the chosen benchmark

Information Coefficient (IC) :Linear relationship between

predicted asset returns and realized returns, usually in the
range of 0 to 1 (unlike correlation range of -1 to 1, as you can
always short the prediction of someone who is consistently
wrong!!).

Number of Bets (N) : Number of independent bets that can be

made in a given time-frame.

Transfer Coefficient (TC) : The linear relationship between

predicted asset returns and actual trading positions. This ideally
should be one, but can be lower (risk limits, capital limit,
bandwidth problem due to work overload etc.)

This makes it clear the essential edge in quantitative trading - N . As

a fundamental investor our edge comes from deep research in to
the underlying securities. This automatically restricts the number of
stocks we can cover. In quant trading, we can observe a very large
number of trading instruments systematically for trading
opportunities.

It does not really mean one style is better compared to another.

While the fundamental trader covers only a few stocks and requires
a much higher level of skills and subjective judgments, the upside
are also potentially large (multi-baggers!). Quant trading requires a
different set of skills and returns are usually more predictable and
steady, if based on solid principles.

Systematic strategy design cycle

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The systematic strategy design cycle looks like below:

The steps consist of the following:

selecting universe : This is the set of trading instruments that

we observe for opportunities. This is usually static (e.g. futures
of the index) or systematically defined (e.g. all stocks in
S&P500 ). It also depends on other factors like geographies,
regulations, fund size, liquidity requirements, investment
mandates etc.

signal generation : This is the step where we continuously

observe and compute a quantitative metric on all instruments in
our universe. It can be a technical indicator like RSI , or a factor
like momentum or combinations of many such metrics. This
defines our potential trading intentions for each of these
instruments.

target portfolio generation : Based on the step above, and

taking in to account our current portfolio and other constraints,
we come up with a target position for each instruments

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(including 0). This is the portfolio we want in our current

strategy iteration.

rebalancing : This is the step where we translate our target

portfolio to actual orders and positions. All order sizing
functions, execution strategies etc. sit here.

improvement : And finally of course we look at the results of the

current iteration and improve our strategy in this continuous
cycle.

Systematic strategy design pillars

The major pillars of a systematic strategy development are defining
strategy inputs, designing the trading rules, validating the trading
rules, portfolio ( meta strategy ) design and risk management.

Inputs: Input to the strategies can come in many flavours like

Price/ returns and it’s transformation. Most of the common

technical indicators are transformation of price returns2

Positioning information – volumes and open interest data

and participant-wise positioning data if available

Fundamental information –macro-economic information,

company fundamentals

Non-market information: Example twitter sentiments,

analysts’ ratings etc.

Trading Rules/ Logic: Can be either based on trader’s

hypothesis or inferred (learned) from data

Form hypothesis (e.g. moving average cross-over signals

change in trends) and test – traditional approach

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Feed data to infer rules (the subject matter of machine

learning and artificial intelligence)

Back-testing and Forward-testing: A crucial step and often

over-looked step.

A good platform to guard against biases : data-mining bias,

survivorship bias, market-impact modeling, look-ahead bias

Should be flexible, event-driven (to avoid look-ahead bias)

and with built-in analytics

Portfolio Creation/ Optimization: Never go all-in with a single

strategy

Two strategies better than one – if they are uncorrelated (in

terms of signals and/ or performance)

Various methods exists – ensemble, traditional portfolio

theory, dynamic portfolio allocation etc.

Risk management in systematic strategy

Risk management is an integral part of systematic strategies and
plays an important role in each part above. It starts with the inputs.
One of biggest issues quant strategies are quality of input data. The
input data quality and timeliness are fundamental in building a solid
and stable strategy. Second, during the research phase, the major
risks are various human conginitive biases (that leads to selective
research and biased outcome) and experimental biases (e.g. data-
mining and overfitting ). One of the major biases during the backtest
phase, which happens to be very frequent among beginners, is the
look ahead bias. An event-driven backtesting engine becomes a
crucial tool to handle such cases.

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Once the strategy is tested and deployed, the risk management

switches to controlling the inputs (data quality) and outputs (orders,
positions etc.) of the strategy. The key parameters to control are

trading frequency - how frequently the algorithm is trading vs.

expectation. A rogue strategy sending orders too fast is known
as machine gunning .

trading amount - how large the individual generated orders

are, compared to expectation. This avoids the fat-finger
problem.

restrictions - several restrictions can be implemented based

on requirements, that keep the strategy under control. This
includes restriction on maximum leverage, maximum exposure,
maximum position size, maximum number of orders in a given
period of time and many others

kill switch - finally, a systematic strategy should always be

built with a kill switch , that enables us to quickly stop the
execution in case things go wrong or the strategy behaves
unexpectedly.

1. See here for example.

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