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Session 1

Introduction

Outline

Definition, Research Areas, Relevance and Applications

Algorithmic Trading Framework

Prop Trading Strategy Steps, Algo Trading Development Cycle

Signal Generation

Mathematical Tools, Attributes of Scientific Trading Models, Backtesting, Calibration and Robustness

Trade Implementation

Performance Analysis

Return, Risk and Efficiency Metrics, Success Factors of Quantitative Trading Strategies and Trading System

Efficiency

Definition, Research Areas and Relevance

Definition: Algorithmic trading is a discipline at the intersection of finance, computer science and mathematics.

It describes the process of using algorithms to generate and execute orders in financial markets. Such algorithms

generate long/short/neutral signals, adapt market quotes and/or execute trading decisions with minimal market

impact and/or improved transaction prices

Computer Science: Build more reliable and faster execution platforms

Mathematics: Build more comprehensive and accurate prediction models

40% of all European equity volume

25% of all Forex transactions

20% of all US option trades

Applications

Algorithmic Execution: Use algorithms to search/discover fragmented liquidity pools to optimize execution

via complex / high frequency order routing strategies. Profit comes from improved prices and reduced market

impact

Example: Order routing to dark pools to improve execution price, iceberg orders to reduce market impact

Market Making: Supply the market with bid ask quotes for financial securities. Ensure the book respects

certain constraints such as delta profile or net position. Profit comes mainly from clients trading activity, hence

the bid-ask spread. Also known as flow trading or sell side. Main risk comes from market moves against position if

net position/Greeks are not perfectly hedged

Example: A broker offers to sell a financial security at the ask and to buy at the bid to earn the spread

Trade Signal Generation: Design proprietary strategies to generate profits by betting on market directions.

Profit comes from winning trades. Also known as propietary trading or buy side. Main risk is that market does not

move as expected/back tested and strategy becomes unprofitable

Example: Buy/sell security when moving averages cross each other

Goals of Trading

Profit Generation

1. Entry: Based on a trade signal, generate order to go short or long a certain financial instrument in a certain

quantity. Trade results in a certain position in this security

2. Mark-to-Market: As the price of the security changes, so does your unrealized PnL.

PnL = Side * Quantity * (Pbid Pask)

3. Exit: Generate order to exit the position and create a realized PnL. Orders to exit are usually one of the

three categories: take profit order, a trailing stop or stop loss order.

PnL = Side * Quantity * (Pexit Pentry)

Hedging

Hedging describes the process of placing a trade to reduce/eliminate a certain kind of exposure

Example: Reduce exposure of an option position to a move of the underlying by entering a delta-neutral

position

Hedging costs money, but reduces uncertainty. Continuous hedging as assumed by much of the academic

literature is neither feasible nor cost effective

Types of Trading

Fundamental:

Quantitative:

Rule based

Econometric Forecasting

Statistical Arbitrage

Technical:

Stock Picking

Ratio Analysis

Sector Analysis

Executive Management Signals

Charting

Trend Analysis

Time Frames:

Instruments and Order Types

Instruments:

Equities

Bonds

Commodities

Foreign Exchange

Credit Default Swaps

Asset Backed Securities

Swaps

Rates

Futures and Options on the above

Order Types:

Market

Limit

Stop Loss

Trailing Stop

Attached Orders

Conditional Orders

Prop Trading Strategy Steps

SIGNAL GENERATION

Proprietary algorithmic trading strategies can be broken down into three subsequent

steps: Signal Generation, Trade Implementation and Performance Analysis

HOW TO TRADE

TRADE

IMPLEMENTATION

The first step, Signal Generation, defines when and how to trade. For example, in a

moving average strategy, the crossing of the shorter running moving average over the

longer running moving average triggers when to trade. Next to long and short, the signal

can also be neutral (do nothing). Using moving averages to generate long/short trading

signals is an example choice of how to trade

Trade Implementation happens after the Signal Generation step has triggered a buy or

sell signal. It determines how the order is structured, e.g. position size and limit levels. In

advanced strategies, it can also take into account cross correlation with other portfolio

holdings and potential portfolio constraints

Performance Analysis is conducted after the trade has been closed and used in a

backtesting context to judge whether the strategy is successful or not. In general, we can

judge the performance according to five different metrics: return, risk, efficiency, trade

frequency and leverage

ORDERS, INCL. EXIT

PERFORMANCE

ANALYSIS

EFFICIENCY RATIOS

Trading System Development Cycle

The development cycle of a quantitative strategy is an iterative process that can be split into 8 steps:

1) Generate or improve a trading strategy idea (based on intuition)

2) Quantify the trading idea and build a model to replicate it

3) Back test the strategy for multiple time frames, trade implementation rules and related financial

instruments

4) Calculate performance, risk and efficiency statistics, choose trade frequency and leverage

6) If the strategy does not add significant value to the existing strategies, restart at step #1

7) Implement the strategy on an execution platform (e.g. Interactive Brokers, Oanda), initially as a paper

trading account

8) Trade the strategy with real money

9

Signal Generation

Mathematical Tools and Attributes of Scientific Trading Models

Mathematical Tools:

Markov Models

Co Integration

Stationarity vs. Non-Stationarity

Mean Reverting Processes

Bootstrapping

Signal Processing Tools

Return Distributions / Lvy Processes

Time Series Modelling

Ensemble Methods

One can specify all assumptions

Models can be quantified from assumptions

Model properties can be deduced from assumptions

Model properties can be back tested in an objective, rule-based manner

Clear Model property specification allows for iterative strategy improvement

10

Signal Generation

Strategy Development and Back Testing

Strategy Development:

Quantify these patterns/trading idea in an initial trading model

Verify if the patterns are persistent/trading idea would have worked in the past

Create a more advanced trading model based on these signals

Back Testing:

Back testing simulates the potential success of a strategy based on historical or simulated data

Gives an estimate how the strategy would have worked in the past, but not if it will work in the future

It is an objective method to conduct performance analysis and choose most promising strategy

Data from Performance Analysis step helps in further strategy improvement and trade implementation, e.g.

determining exit order levels

11

Signal Generation

Calibration and Robustness

Calibration:

Most strategies calibrate model parameters to optimize certain performance analysis factors, e.g. total return

Calibration is an inverse process: we know how to get from market data to model parameters when we have a

model, but not how to get to the most realistic model from market data alone

Occams razor: Fewer parameters are usually preferable and tend to increase model robustness

Robustness:

How much does the success of a strategy change given a small variation in parameter values?

Avoid in-sample overfitted parameters out of sample testing is crucial!!!

Plot of performance measure vs. delta of or absolute parameter(s) values visualizes parameter sensitivity

We look for plateaus where a broader range of parameters results in stable performance measures

Ensembles of different models can help to increase meta model robustness

12

Trade Implementation

Order Manipulation Process

Portfolio Analysis: Cross correlation with other portfolio positions, position limits, portfolio constraints

What if an order is already filled before a modify command arrives at the market?

What if an old order is partially filled and then deleted/reduced?

What if a confirmation arrives too late (or never arrives)?

What if the price moves again before the new limit order is placed?

What if the new order is rejected by the Market ?

What if the new order breaks position limits or portfolio constraints?

What if the gateway, market or broker is down?

13

Trade Implementation

Exit Orders

Implement Take Profit orders or keep positions until signal direction changes?

Stop Loss vs. Trailing Stop to limit downside? Optimal distance of Stop Level to Market?

Time in Force for Orders, Maximum Holding Period for portfolio constituents?

14

Performance Analysis

Return, Risk and Efficiency Metrics

Return Metrics:

Total Return, Annualized Return, Winning %, Avg. Winning Size, Biggest Winner, Distribution of Winning

Trades, Loosing %, Avg. Loosing Size, Biggest Looser, Distribution of Losing Trades

Risk Measures:

Efficiency Measures:

Sharpe, Information and Sortino Ratio

Trade Frequency:

Leverage:

Unleveraged ( 100% of equity value) or leveraged positions ( 100% of equity value)? Costs of leverage?

15

Performance Analysis

Success Factors of Quantitative Trading Strategies

Quantitative Investment Strategies are driven by four success factors: trade frequency,

success ratio, return distributions when right/wrong and leverage ratio

The two graphs show 95% confidence levels of annualized expected returns of two

underlyings exhibiting different volatilities (7.8% annualized for AUDJPY vs. 64.6% for

VIX) and daily trade frequency. The higher the success ratio, the more likely it is to

achieve a positive return over a one year period. Higher volatility of the underlying

assuming constant success ratio will lead to higher expected returns

The distribution of returns when being right / wrong is especially important for strategies

with heavy long or short bias. Strategies with balanced long/short positions on any

underlying are less impacted by these distributional patterns. Downside risk can further be

limited through active risk management, e.g. stop loss orders

Leverage plays an important role to scale returns and can be seen as an artificial way to

increase the volatility of the traded underlying. For example, a 10 times leveraged position

on an asset with 1% daily moves is similar to a non-leveraged position on an asset with

10% daily moves

Assuming daily trade frequency, a success ratio of 54%, even long/short return

distributions and a leverage ratio of 100% implies a probability of less than 5% of nonpositive annual returns

0.2

0.0

-0.2

0.4

AUDJPY Curncy

0.50

0.52

0.54

0.56

0.58

2

1

0

-1

-2

VIX Index

0.50

0.52

0.54

0.56

0.58

16

Performance Analysis

Trading System Efficiency

Van Tharp introduced the concept of R multiple. 1 R measures the initial risk of a position, which is equal to the

distance between entry and stop loss level. Exit levels should be chosen so that the gains are higher than 1R. This is

another way of saying cut losses short and let profits run. Example: Enter long position at 10 EUR with stop loss

order at 9 EUR. 1R= initial risk = 10%

Gain in %= frequency of trades * (winning % * avg. winning size loosing % * avg. loosing size) * leverage ratio

loosing % = 1 winning % and avg. winning size = n * R, with n = average win to loss ratio

Gain in % = frequency of trades * (winning % * n * R (1 winning %) * R) * leverage ratio * 1/100

Example: A strategy trades daily, has a success ratio of 60%, equal average winning and losing size of 1 % and

trades a leverage ratio of 200% of equity. In this case, the expected yearly gain is:

= 100% p.a.

= 100% p.a.

In this business if you're good, you're right six times out of ten.You're never going to be right nine times out of ten. . Peter Lynch

17

Algorithmic trading is an emerging, intellectually challenging field in quantitative finance where computer science is

as important as mathematics

Successful firms are either faster (computer science) or have better forecasting accuracy (mathematics) than the

competition, or both

A scientific approach to algorithmic trading helps to differentiate signals from noise / chance from recurring patterns

Proprietary algorithmic trading strategies can be broken down into three subsequent steps: Signal Generation, Trade

Implementation and Performance Analysis

Questions?

18

AlgorithmicTrading

Session 2

Success and Risk Factors of

Quantitative Trading Strategies

Oliver Steinki, CFA, FRM

Outline

Introduction

Basic Concepts

Mathematical Expectation

Kelly Criteria

Introduction

Risk / Money Management as a Performance Driver

The performance of any trading strategy is driven by the mathematical expectation of the strategy and

the position size taken. Obviously, position sizing (money management) is related to the size of your account

level, but how exactly does it relate?

We do not have control whether the next trade will be profitable or not as it is a mathematical expectations game.

Yet, we do have control over the quantity we have on. Since one does not dominate the other, our resources are

better spent concentrating on putting on the right quantity

Risk management is about decision making strategies that aim to maximize the risk / return ratio within a given

level of acceptable risk.

Example: Your client gives you a drawdown limit of 5%. Hence, you would like to optimize your trading

strategy in terms of risk / return tradeoff, however it has to be done in a way that it must not breach the

drawdown constraint

Several concepts of money management will be explained by using gambling concepts. The mathematics of money

management and the principles involved in trading and gambling are quite similar. The main difference is that in the

math of gambling we are usually dealing with Bernoulli outcomes (only two possible outcomes), whereas in trading

we are dealing with an entire probability distribution that the PnL may take

Performance Drivers

Performance Drivers of Quantitative Trading Strategies I

Quantitative Investment Strategies are driven by four success factors: trade frequency, success ratio, return

distributions when right/wrong and leverage ratio

The higher the success ratio, the more likely it is to achieve a positive return over a one year period. Higher

volatility of the underlying assuming constant success ratio will lead to higher expected returns

The distribution of returns when being right / wrong is especially important for strategies with heavy long or short

bias. Strategies with balanced long/short positions and hence similar distributions when right/wrong are less

impacted by these distributional patterns. Downside risk can further be limited through active risk/money

management, e.g. stop loss orders

Leverage plays an important role to scale returns and can be seen as an artificial way to increase the volatility of

the traded underlying. It is at the core of the money management question to determine the ideal betting size. For

example, a 10 times leveraged position on an asset with 1% daily moves is similar to a full non-leveraged position

on an asset with 10% daily moves

Performance Drivers

Performance Drivers of Quantitative Trading Strategies II

Van Tharp introduced the concept of R multiple. 1 R measures the initial risk of a position, which is equal to the

distance between entry and stop loss level. This assumes that one would be executed at stop loss level. Exit levels

should be chosen so that the gains are higher than 1R. This is another way of saying cut losses short and let profits

run. Example: Enter long position at 10 EUR with stop loss order at 9 EUR. 1R= initial risk = 10%

Gain in %= frequency of trades * (winning % * avg. winning size loosing % * avg. loosing size) * leverage ratio

loosing % = 1 winning % and avg. winning size = n * R, with n = average win to loss ratio

Example: A strategy trades daily, has a success ratio of 60%, equal average winning and losing size of 1 % and

trades a leverage ratio of 200% of equity. In this case, the expected yearly gain is:

Gain = 250 * (60% * 1 % 40% * 1 %) * 2

= 100% p.a.

= 100% p.a.

Basic Concepts

Ultimately, we have no control over whether the next trade will be profitable or not. Yet we do have control over

the quantity we have on. Since one does not dominate the other, our resources are better spent concentrating on

putting on the tight quantity

The worst case loss on any given trade (which could be ensured through a stop loss, but does not necessarily have

to) together with the level of equity in your account, should be the base for your position sizing, e.g. how many

contracts to trade

The divisor f of this biggest perceived loss is a number between 0 and 1 which determines how many contracts to

trade. Assuming a portfolio of $50.000, a worst case loss of $5.000 per contract and a position of five contracts,

this divisor is calculated as:

$50.000 / ($5000 / f) = 5,

Thus, you trade 1 contract per $10.000 in equity with a divisor f of 0.5

This divisor we will call by its variable name f. Thus, whether consciously or subconsciously, on any given trade

you are selecting a value for f when you decide how many contracts or shares to put on.

Mathematical Expectation

Mathematical Expectation (ME) is the amount you expect to make or lose, on average, each bet (trade)

ME = = 1, ( ), with

P = Probability of winning

N = Number of possible outcomes

The mathematical expectation is computed by multiplying each possible gain or loss by its corresponding

probability and then summing these products

Exampe: Consider a game with a 50% chance of winning $2 and a (1-50%) = 50% chance of losing $1

The expected profit per game is hence $0.5. This is a typical example of a game with an edge as the ME in a fair

game should be $0.

In a negative expectation game, there is no money management scheme that will create a winning strategy. If you

continue to trade a negative expectation game, you will lose your entire stake in the long run.

7

Reinvesting trading profits can turn a winning system into a losing system but not vice versa. A winning system

becomes a losing system if returns are not consistent enough

Changing the order or sequence of trades does not affect the final outcome, neither on a non reinvestment basis,

nor on a reinvestment basis

Reinvesting turns the linear growth function of a trading strategy with positive mathematical expectation into an

exponential growth function

The geometric mean is the best system to measure the tradeoff between profitability and consistency. It is

calculated as the Nth root of the Terminal Wealth Relative (TWR). TWR represents the return on your stake as a

multiple of your initial investment

= 1, , with

For the three systems analyzed in excel, the TWRs and geometric means are as follows:

=(

System

System A

System B

System C

TWR

0.918

1.071

1.041

Geometric Mean

0.979

1.017

1.010

8

So far, we have shown that reinvestment of returns leads to the highest geometric return and should therefore be

used. We have implicitly assumed that we would reinvest at any time 100% of our equity. However, this is not

ideal.

Consider again our coin toss game: 50% chance of winning $2, 50% chance of losing 1%. What would be the ideal

size to bet? If you bet 100% each time, you will be wiped out sooner or later. If you only bet $1 each time, you do

not reinvest. Hence, the ideal betting size is somewhere in between these extremes

Consider the ideal strategy for a negative expectancy game: You want to bet on as few trades as possible as your

likelihood of losing increases with the number of trials.

Example: You are forced to play a game with 49% chance of winning $1, 51% chance of losing $1. The more

often you bet, the greater the likelihood you will lose, hence you should only bet once.

Returning to the positive expectancy game: The quantity f, that a trader can put on, lies between 0 and 1. f

represents the traders quantity relative to the perceived loss and total equity. As you know you have an edge over

N bets, but not which bets will be losers/winners and by how much, the best way is to bet a constant percentage of

your total equity. We are hence investigating the question of how to best exploit a positive expectation game?

The answer: For an independent trials process, this is achieved by reinvesting a fixed fraction f of your total stake

9

Kelly Criteria

The Kelly criteria deals with the question of optimal f in a gambling context. It states that we should bet that fixed

fraction of our stake (f) which maximizes the growth function G(f) for events with two possible outcomes:

= ln 1 + + + 1 ln 1 , with

P = the probability of a winning bet

ln = the natural logarithm function

Kelly formula applicable for events with equal wins and losses:

= , or = (2 ) 1, which are equivalent, with

Q = complement of P (1 P)

Example: Consider the following stream of bets: -1,+1,+1,-1,-1,+1,+1,-1,+1,+1

f = 0.6 0.4 = 0.2 or (0.6 * 2) 1 = 0.2

10

Kelly Criteria

Kelly formula applicable for events with unequal wins and losses:

Example: the two to one coin toss example

f = ((2+1) * .5 1) / 2

= (3 * 0.5 1) /2 = 0.5 / 2 = 0.25

However, the Kelly formula is only applicable to outcomes that have a Bernoulli distribution. A Bernoulli

distribution has only two possible discrete outcomes. Hence, the Kelly formula is applicable for gambling, but not

for trading, where we have more than two possible outcomes and the Kelly formula would yield wrong results for

the optimal f

f = ME / B = 0.5 / 2 = 0.25 in the two to one coin toss example

11

To find the optimal f for trading, we must amend our formula to find Holding Period Returns (HPR):

= 1 +

, with

-Trade = the inverse of the PnL on any given trade (profits are negative, losses positive numbers)

Biggest Loss = The PnL that resulted in the biggest loss (always negative)

= = 1, (1 +

= = 1, (1 +

(1/)

(

)

),

G = Geometric mean of the HPRs

We find the f that results in the highest G by looping through all possible f values starting at 0 in 0.01 increments

and stop as soon as G starts decreasing as the f function has only one peak

12

Examples

# of loops

1

20

50

100

Difference

1.096

1.085

1%

6.220

5.125

21%

96.506

59.453

62%

9,313.314

3,534.708

163%

As you see, using the optimal f does not appear to offer much advantage over the short run, but over the long run it

becomes more and more important. The point is, you must give the program time when trading at the optimal f

and not expect miracles in the short run. The more time (i.e., bets or trades) that elapses, the greater the difference

between using the optimal f and any other money-management strategy

13

We do not have control whether the next trade will be profitable or not. Yet, we do have control over the quantity

we have on. Since one does not dominate the other, our resources are better spent concentrating on putting on the

right quantity

The Kelly formula is only applicable to outcomes that have a Bernoulli distribution. It is a common mistake among

traders to use it for trading

Optimal f is the mathematical way to maximize the geometric mean of your trading system and hence the way to size

positions if you want to exploit a positive expectancy game in the most efficient manner

Questions?

14

AlgorithmicTrading

Session 3

Trade Signal Generation I

FindingTrading Ideas and Common Pitfalls

Oliver Steinki, CFA, FRM

Outline

Introduction

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

As we have seen, algorithmic proprietary trading strategies can be broken down into

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

The first step, Signal Generation, defines when and how to trade. For example, in a

moving average strategy, the crossing of the shorter running moving average over the

longer running moving average triggers when to trade. Next to long and short, the signal

can also be neutral (do nothing). Using moving averages to generate long/short trading

signals is an example choice of how to trade

Sessions 3 6 deal with the question of deciding when and how to trade

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

PERFORMANCE

ANALYSIS

Pitfalls

Session 4: Backtesting

Session 5: Mean Reversion Strategies

Session 6: Momentum Strategies

EFFICIENCY RATIOS

Introduction

Signal Generation

Signal Generation describes the process of deciding when and how to trade

Finding a trading idea is actually not the hardest part of building a quantitative trading strategy. There are hundreds,

if not thousands, of trading ideas that are in the public sphere at any time, accessible to anyone at little or no cost.

Many authors of these trading ideas will tell you their complete methodologies in addition to their backtest results.

There are finance and investment books, newspapers and magazines, mainstream media web sites, academic papers

available online or in the nearest public library, trader forums, blogs etc.

Avoid common trading strategy pitfalls. Several checks can tell you quite quickly whether you should further

investigate a strategy or not

Where can you find good trading ideas?

strategies is not difficult.There are:

Trader Forums

Table taken from the book How to Build Your Own Algorithmic Trading Business by E. Chan

Which Strategy Suits You?

Finding a viable strategy that suits you often does not have anything to do with the strategy itself, rather with your

constraints:

How much time do you have for baby-sitting your trading programs? Do you trade part time? If so, you

would probably want to consider only strategies that hold overnight and not the intraday strategies.

Otherwise, you may have to fully automate your strategies

How good a programmer are you? If you know some programming languages such as Visual Basic,

MATLAB, R or even Java, C#, or C++, you can explore high-frequency strategies, and you can also trade a

large number of securities. Otherwise, settle for strategies that trade only once a day, or trade just a few

stocks, futures, or currencies

How much capital do you have available for trading? Do you have a lot of capital available for trading as

well as expenditure on infrastructure and operation? In general, I would not recommend quantitative trading

for an account with less than EUR 50,000

Is your goal to earn steady monthly income or to strive for a large, long-term capital gain? Most

people who choose to become traders want to earn a steady (hopefully increasing) monthly, or at least

quarterly, income. But you may be independently wealthy, and long-term capital gain is all that matters to

you

6

How Does Capital Availability Affect Your Choices?

Table taken from the book How to Build Your Own Algorithmic Trading Business by E. Chan

Quick Checks

Before doing an in-depth backtest of the strategy, you can quickly filter out unsuitable strategies if they fail one or

more of these tests:

Does it have a small enough drawdown and short enough drawdown duration?

Benchmark Outperformance and Performance Consistency

How compares the strategy with a benchmark and how consistent are its returns? Return comparisons are easy for

long- only stock strategies, but more difficult for advanced strategies such as long/short equity

Another issue to consider is the consistency of the returns generated by a strategy. Though a strategy may have the

same average return as the benchmark, perhaps it delivered positive returns every month while the benchmark

occasionally suffered some very bad months. In this case, we would still deem the strategy superior than the

benchmark. Always use measures such as Information, Sharpe (Information ratio with benchmark returns equal

to the risk free asset) or Sortino ratio to measure risk adjusted performance, never return alone

Information ratio:

Sortino ratio:

Drawdowns

How deep and long is the drawdown? A strategy suffers a drawdown whenever it has lost money recently. A

drawdown at a given time t is defined as the difference between the current equity value (assuming no redemption

or cash infusion) of the portfolio and the global maximum of the equity curve occurring on or before time t. The

maximum drawdown is the difference between the global maximum of the equity curve with the global

minimum of the curve after the occurrence of the global maximum

Are there any client specific or risk management imposed drawdown constraints?

Graph taken from the book How to Build Your Own Algorithmic Trading Business by E. Chan

10

Transaction Costs

Every time a strategy buys and sells a security, it incurs a transaction cost. The more frequent it trades, the larger

the impact of transaction costs will be on the profitability of the strategy. These transaction costs are not just due to

commission fees charged by the broker.There exist also exchange fees as well as stamp duty fees

There will also be the cost of liquidity - when you buy and sell securities at their market prices, you are paying

the bid-ask spread. If you buy and sell securities using limit orders, however, you avoid the liquidity costs but

incur opportunity costs

When you buy or sell a large chunk of securities, you will not be able to complete the transaction without

impacting the prices at which this transaction is done. This effect on the market prices due to your own order is

called market impact, and it can contribute to a large part of the total transaction cost when the security is not

very liquid.Algorithmic execution models try to limit these market impact costs

There can also be a delay between the time your strategy transmits an order to the broker and the time it is

executed at the exchange, due to slow internet connection or slow software. This delay can cause slippage, the

difference between the price that triggers the order and the actual execution price

11

Survivorship Bias

A historical database of asset prices such as stocks that does not include stocks that have disappeared due to

bankruptcies, delistings, mergers, or acquisitions suffer from the so-called survivorship bias, because only

survivors of those often unpleasant events remain in the database

Same problem applies to mutual fund or hedge fund databases that do not include funds that went out of

business, usually due to negative performance

Survivorship bias is especially applicable to value strategies, e.g. investment concepts that buy stocks that

seem to be cheap. Some stocks were cheap because the companies were going bankrupt shortly. So if your strategy

includes only those cases when the stocks were very cheap but eventually survived (and maybe prospered) and

neglects those cases where the stocks finally did get delisted, the backtest performance will be much better than

what a trader would actually have suffered at that time

12

Data Snooping Bias In Sample Over-Optimization

If you build a trading strategy that has 100 parameters, it is very likely that you can optimize those parameters in a

way that the historical performance looks amazing. It is also very likely that the future performance of this strategy

will not at all look like this over-optimized historical performance

Data snooping is very difficult to avoid even if you have just one or two parameters (such as entry and exit

thresholds). We will further investigate this issue in Session 4, when we discuss backtesting and common backtesting

pitfalls

In general, the more rules a strategy has, and the more parameters the model has to optimize, the more likely it is

to suffer from data-snooping bias

The following general rules based on Occams razor help to avoid data snooping bias in quantitative trading

strategies:

Strategy is based on a sound econometric or rational basis, and not on random discovery of patterns

All optimizations must occur in a backward looking moving window, involving no future unseen data. And

the effect of this optimization must be continuously demonstrated using this future, unseen data

13

Finding quantitative trading ideas is not that difficult. There are many finance and investment books, newspapers and

magazines, mainstream media web sites, academic papers available online or in the nearest public library, trader

forums, blogs etc. which can be used to form intuitive ideas which are then transformed into trading signals

Finding a viable strategy that suits your constraints is more difficult. Consider your time and capital limitations as

well as your programming skills. You also have to decide whether you want to earn a steady monthly income or if

you want to strive for a larger, long-term capital gain

Before backtesting a strategy, you can filter out many unviable strategies based on a quick check. These checks

analyse the strategy regarding its outperformance of relevant benchmarks, its risk-adjusted returns, and drawdown

characteristics. You should also check whether your strategy suffers from survivorship bias or data snooping

Questions?

14

Sources

Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernest Chan

The Mathematics of Money Management: Risk Analysis Techniques for Traders by Ralph Vince

15

Algorithmic Trading

Session 4

Trade Signal Generation II

Backtesting

Oliver Steinki, CFA, FRM

Outline

Introduction

Backtesting

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

As we have seen, algorithmic proprietary trading strategies can be broken down into

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

The first step, Signal Generation, defines when and how to trade. For example, in a

moving average strategy, the crossing of the shorter running moving average over the

longer running moving average triggers when to trade. Next to long and short, the signal

can also be neutral (do nothing). Using moving averages to generate long/short trading

signals is an example choice of how to trade

Sessions 3 6 deal with the question of deciding when and how to trade

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Todays Session 4: Backtesting

Session 5: Mean Reversion Strategies

Session 6: Momentum Strategies

PERFORMANCE

ANALYSIS

EFFICIENCY RATIOS

Introduction

Backtesting

Signal Generation describes the process of deciding when and how to trade. Backtesting is the process of

feeding historical data to your trading strategy to see how it would have performed. A key difference between a

traditional investment management process and an algorithmic trading process is the possibility to do so

However, if one backtests a strategy without taking care to avoid common backtesting pitfalls, the whole

backtesting procedure will be useless. Or worse - it might be misleading and may cause significant financial losses

Since backtesting typically involves the computation of an expected return and other statistical measures of the

performance of a strategy, it is reasonable to question the statistical significance of these numbers. We will discuss

the general way to estimate statistical significance using the methodologies of hypothesis testing and Monte Carlo

simulations. In general, the more round trip trades there are in the backtest, the higher will be the statistical

significance

But even if a backtest is done correctly without pitfalls and with high statistical significance, it doesnt necessarily

mean that it is predictive of future returns. Regime shifts can spoil everything, and a few important historical

examples will be highlighted

Backtesting

Why is Backtesting Important?

Backtesting is the process of feeding historical data to your trading strategy to see how it would have performed.

The idea is that the backtested performance of a strategy tells us what to expect as future performance

Whether you have developed a strategy from scratch or you read about a strategy and are sure that the published

results are true, it is still imperative that you independently backtest the strategy. There are several reasons to do

so:

The profitability of a strategy often depends sensitively on the details of implementation, e.g. which prices

(bid, ask, last traded) to use for signal generation (trigger) and as entry /exit points (execution)

Only if we have implemented the backtest ourselves, we can analyze every little detail and weakness of the

strategy. Hence, by backtesting a strategy ourselves, we can find ways to refine and improve the strategy,

hence to improve its risk/reward ratio

Backtesting a published strategy allows you to conduct true out-of-sample testing in the period following

publication. If that out-of-sample performance proves poor, then one has to be concerned that the strategy

may have worked only on a limited data set

The full list of potential backtesting pitfalls is quite long, but we will look at a few common mistakes on the

next pages

5

Look-Ahead Bias

As the name suggests, look-ahead bias describes a strategy which uses data at time t1 to determine a trading signal at

t0 . A common example of look-ahead bias is a strategy that uses the high or low of a trading day as a trigger. This

assumption is not realistic as we only know the high / low after market close

Look-ahead bias is essentially a programming error and can infect only a backtest program but not a live trading

program because there is no way a live trading program can obtain future information

Hence, If your backtesting and live trading programs are one and the same, and the only difference between

backtesting versus live trading is what kind of data you are feeding into the program, youre pretty safe to avoid

look-ahead bias

Data Snooping Bias In Sample Over-Optimization

If you build a trading strategy that has 100 parameters, it is very likely that you can optimize those parameters in a

way that the historical performance looks amazing. It is also very likely that the future performance of this strategy

will not at all look like this over-optimized historical performance

In general, the more rules a strategy has, and the more parameters the model has to optimize, the more likely it is

to suffer from data-snooping bias

The way to detect data-snooping bias is easy: We should test the model on out-of-sample data and reject a model

that doesnt pass the out-of sample test

Cross-validation is probably the best way to avoid data snooping. That is, you should select a number of different

subsets of the data for training and tweaking your model and, more important, making sure that the model

performs well on these different subsets. One reason why one prefers models with high risk/return ratios and short

maximum drawdown durations is that this is an indirect way to ensure that the model will pass the cross-validation

test: the only subsets where the model will fail the test are those rare drawdown periods

Survivorship Bias

A historical database of asset prices such as stocks that does not include stocks that have disappeared due to

bankruptcies, delistings, mergers, or acquisitions suffer from the so-called survivorship bias, because only

survivors of those often unpleasant events remain in the database

Same problem applies to mutual fund or hedge fund databases that do not include funds that went out of business,

usually due to negative performance

Survivorship bias is especially applicable to value strategies, e.g. investment concepts that buy stocks that seem to be

cheap. Some stocks were cheap because the companies were going bankrupt shortly. So if your strategy includes

only those cases when the stocks were very cheap but eventually survived (and maybe prospered) and neglects those

cases where the stocks finally did get delisted, the backtest performance will be much better than what a trader

would actually have suffered at that time

Stock Splits and Dividend Adjustments

Whenever a companys stock has an N-to-1 split, the stock price will be divided by N times. However, if you own a

number of shares of that companys stock before the split, you will own N times as many shares after the split, so

there is in fact no change in the total market value

However, in a backtesting environment, we often consider only at the price series to determine our trading signals,

not the market-value series of some hypothetical account. So unless we back-adjust the prices before the ex-date of

the split by dividing them by N, we will see a sudden drop in price on the ex-date, and that might trigger some

erroneous trading signals

Similarly, when a company pays a cash (or stock) dividend of $d per share, the stock price will also go down by $d

(absent other market movements). That is because if you own that stock before the dividend ex-date, you will get

cash (or stock) distributions in your brokerage account, so again there should be no change in the total market value

If you do not back-adjust the historical price series prior to the ex-date, the sudden drop in price may also trigger

an erroneous trading signal

Trading Venue Dependency and Short Sale Constraints

Most larger stocks are listed on multiple exchanges, electronic communicatin networks (ECNs) and dark pools. The

historical last daily price might have occurred on any of those trading venues. However, if you enter a market on

open (MOO) or market on close order (MOC), this order will be routed to the primary exchange only. Hence,

your backtested performance based on open or close might be different to a live trading performance based on

MOO/MOC

Foreign Exchange (FX) markets are even more fragmented and there is no rule that says a trade executed at one

venue has to be at the best bid or ask across all the different FX venues

A stock-trading model that involves shorting stocks assumes that those stocks can be shorted, but often there are

difficulties in shorting some stocks. This might either be due to limited availability of your broker to locate such

stocks or due to regulatory reasons. For example, many European countries and the USA prohibited the short sale

of financial stocks during the financial crisis

10

Futures Continuous Contracts and Futures Close vs. Settlement Prices

Futures contracts have expiry dates, so a trading strategy on, say, volatility futures, is really a trading strategy on

many different contracts. Usually, the strategy applies to front-month contracts. Which contract is the front month

depends on exactly when you plan to roll over to the next month; that is, when you plan to sell the current front

contract and buy the contract with the next nearest expiration date. Hence, when choosing a data vendor for

historical futures prices, you must understand exactly how they have dealt with the back-adjustment issue, as it

certainly impacts your backtest

The daily closing price of a futures contract provided by a data vendor is usually the settlement price, not the last

traded price of the contract during that day. Note that a futures contract will have a settlement price each day

(determined by the exchange), even if the contract has not traded at all that day. And if the contract has traded, the

settlement price is in general different from the last traded price. Most historical data vendors provide the

settlement price as the daily closing price, which can not be replicated via MOC orders in a live strategy

environment

11

Hypothesis Testing

In any backtest, we face the problem of finite sample size: Whatever statistical measures we compute, such as

average returns or maximum drawdowns, are subject to randomness. In other words, we may just be lucky that our

strategy happened to be profitable in a small data sample. Statisticians have developed a general methodology called

hypothesis testing to address this issue.The hypothesis testing framework applied to backtesting follows these steps:

1.

Based on a backtest on some finite sample of data, we compute a certain statistical measure called the test

statistic. For concreteness, lets say the test statistic is the average daily return of a trading strategy in that

period

2.

We suppose that the true average daily return based on an infinite data set is actually zero. This supposition is

called the null hypothesis

3.

We suppose that the probability distribution of daily returns is known. This probability distribution has a

zero mean, based on the null hypothesis.We describe later how we determine this probability distribution

4.

Based on this null hypothesis probability distribution, we compute the probability p that the average daily

returns will be at least as large as the observed value in the backtest (or, for a general test statistic, as

extreme, allowing for the possibility of a negative test statistic). This probability p is called the p-value, and if

it is very small (lets say smaller than 0.01), that means we can reject the null hypothesis, and conclude that

the backtested average daily return is statistically significant and not equal to 0

12

Three Ways to Determine the Probability Distribution

Step 3 of the described Hypothesis Testing Framework requires the most thought. How do we determine the

probability distribution under the null hypothesis? There are three ways to do so:

1.

We assume the daily returns follow a standard parametric distribution such as the Gaussian one. If we do

this, it is clear that if the backtest has a high Sharpe ratio, it would be very easy for us to reject the null

hypothesis. This is because the standard test statistic for a Gaussian distribution is none other than the

average divided by the standard deviation and multiplied by the square root of the number of data points

2.

Another way to estimate the probability distribution of the null hypothesis is to use Monte Carlo methods to

generate simulated historical price data and feed these simulated data into our strategy to determine the

empirical probability distribution of profits. If we do so with the same first moments and the same length as

the actual price data, and run the trading strategy over all these simulated price series, we can find out in

what fraction p of these price series are the average returns greater than or equal to the backtest return.

Ideally, p will be small, which allows us to reject the null hypothesis.

3.

Andrew Lo suggested a third way to estimate the probability distribution: instead of generating simulated

price data, we generate sets of simulated trades, with the constraint that the number of long and short entry

trades is the same as in the backtest, and with the same average holding period for the trades. These trades

are distributed randomly over the actual historical price series. We then measure what fraction of such sets

of trades has average return greater than or equal to the backtest average return

13

Will a Backtest Be Predictive of Future Returns?

Even if we manage to avoid all the common backtesting pitfalls outlined earlier and there are enough trades to

ensure statistical significance of the backtest, the predictive power of any backtest rests on the central assumption

that the statistical properties of the price series are unchanging, so that the trading rules that were profitable in the

past will be profitable in the future.This assumption has often been invalidated in the past:

The 2008 financial crisis that induced a subsequent 50 percent collapse of average daily trading volumes.

Retail trading and ownership of common stock was particularly reduced. This has led to decreasing average

volatility of the markets, but with increasing frequency of sudden outbursts such as that which occurred

during the flash crash in May 2010 and the U.S. federal debt credit rating downgrade in August 2011

The same 2008 financial crisis, which also initiated a multiyear bear market in momentum strategies

The removal of the old uptick rule for short sales in June 2007 and the reinstatement of the new Alternative

Uptick Rule in 2010

14

Backtesting is useless if it is not predictive of future performance of a strategy, but pitfalls in backtesting will

decrease its predictive power

Make sure to avoid the following backtesting pitfalls: look-ahead bias, data-snooping and survivorship bias. Make

sure your data is adjusted for stock splits and dividends. It should also take into account trading venue dependency

and short sale constraints. Furthermore, roll returns and differences between closing and settlement prices need to

be incorporated in your backtesting framework

Make sure your backtested results are statistically significant. Use one of three described ways to determine the

probability distribution under the null hypothesis. If possible, use data-validation

Even if you avoid all common pitfalls and ensure that your results are statistically significant, regime shifts could still

make your strategy unprofitable in a live trading environment.

Questions?

15

Sources

Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernest Chan

The Mathematics of Money Management: Risk Analysis Techniques for Traders by Ralph Vince

16

Algorithmic Trading

Session 5

Trade Signal Generation III

Mean Reversion Strategies

Oliver Steinki, CFA, FRM

Outline

Introduction

Mean Reversion

Stationarity

Cointegration

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

As we have seen, algorithmic proprietary trading strategies can be broken down into

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

moving average strategy, the crossing of the shorter running moving average over the

longer running moving average triggers when to trade. Next to long and short, the signal

can also be neutral (do nothing). Using moving averages to generate long/short trading

signals is an example choice of how to trade

Sessions 3 6 deal with the question of deciding when and how to trade

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Session 4: Backtesting

Todays Session 5: Mean Reversion Strategies

Session 6: Momentum Strategies

PERFORMANCE

ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

Introduction

Mean Reversion vs. Momentum

Trading strategies can be profitable only if securities prices are either mean-reverting or trending.

Otherwise, they are random walking, and trading will be futile. If you believe that prices are mean reverting and

that they are currently low relative to some reference price, you should buy now and plan to sell higher later.

However, if you believe the prices are trending and that they are currently low, you should (short) sell now and plan

to buy at an even lower price later.The opposite is true if you believe prices are high

Academic research has indicated that stock prices are on average very close to random walking. However,

this does not mean that under certain special conditions, they cannot exhibit some degree of mean reversion or

trending behaviour. Furthermore, at any given time, stock prices can be both mean reverting and trending

depending on the time horizon you are interested in. Constructing a trading strategy is essentially a matter of

determining if the prices under certain conditions and for a certain time horizon will be mean reverting or

trending, and what the initial reference price should be at any given time

Mean Reversion

What is Mean Reversion?

Most price series are not mean reverting, but are geometric random walks. The returns, not the prices, are the ones

that usually randomly distribute around a mean of zero. Unfortunately, one cannot trade directly on the mean

reversion of returns (One should not confuse mean reversion of returns with anti-serial-correlation of returns,

which we can definitely trade on. But anti-serial-correlation of returns is the same as the mean reversion of prices).

Those few price series that are found to be mean reverting are called stationary, and we will see the statistical

tests (ADF test, the Hurst exponent and Variance Ratio test) for stationarity

Fortunately, we can manufacture many more mean-reverting price series than there are traded assets because we

can often combine two or more individual price series that are not mean reverting into a portfolio whose net

market value (i.e., price) is mean reverting. Those price series that can be combined this way are called

cointegrating, and we will describe the statistical tests (CADF test and Johansen test) for cointegration

Also, as a by-product of the Johansen test, we can determine the exact weightings of each asset in order to create a

mean reverting portfolio. Because of this possibility of artificially creating stationary portfolios, there are numerous

opportunities available for mean reversion traders

Stationarity

Mean Reversion vs. Stationarity and Tests to Discover It

Mean reversion and stationarity are two equivalent ways of looking at the same type of price series, but these

two ways give rise to two different statistical tests for such series

The mathematical description of a mean-reverting price series is that the change of the price series in the

next period is proportional to the difference between the mean price and the current price. This gives rise to the

ADF test, which tests whether we can reject the null hypothesis that the proportionality constant is zero

However, the mathematical description of a stationary price series is that the variance of the log of the prices

increases slower than that of a geometric random walk. That is, their variance is a sublinear function of time, rather

than a linear function, as in the case of a geometric random walk. This sublinear function is usually approximated by

2H, where is the time separating two price measurements, and H is the so-called Hurst exponent, which is less

than 0.5 if the price series is indeed stationary (and equal to 0.5 if the price series is a geometric random walk). The

Variance Ratio test can be used to see whether we can reject the null hypothesis that the Hurst exponent is

actually 0.5.

Note that stationarity is somewhat of a misnomer: It doesnt mean that the prices are necessarily range

bound, with a variance that is independent of time and thus a Hurst exponent of zero. It merely means that the

variance increases slower than normal diffusion.

Mean Reversion

Augmented Dickey Fuller Test

If a price series is mean reverting, then the current price level will tell us something about what the prices next

move will be: If the price level is higher than the mean, the next move will be a downward move; if the price level

is lower than the mean, the next move will be an upward move. The ADF test is based on just this observation. We

can describe the price changes using a linear model:

= 1 + + + 1 1 + + +

The ADF test will find out if = . If the hypothesis = 0 can be rejected, it means that the next move of the

asset is dependent on the current level and therefore not random

The statisticians Dickey and Fuller described the distribution of this test statistic and tabulated the critical values for

us, so we can look up for any value of /SE() whether the hypothesis can be rejected at, say, the 95 percent

probability level

Since we expect mean regression, /SE() has to be negative, and it has to be more negative than the critical value

for the hypothesis to be rejected. The critical values themselves depend on the sample size and whether we assume

that the price series has a non-zero mean / or a steady drift t/. Most practitioners assume the drift term

to be zero

Stationarity

Hurst Exponent

Intuitively speaking, a stationary price series means that the prices diffuse from its initial value more slowly than a

geometric random walk would. Mathematically, we can determine the nature of the price series by measuring this

speed of diffusion.The speed of diffusion can be characterized by the variance

= + ()

random walk, we know that

+ ()

The means that this relationship turns into an equality with some proportionality constant for large , but it

may deviate from a straight line for small . But if the (log) price series is mean reverting or trending (i.e., has

positive correlations between sequential price moves), the last equation wont hold. Instead, we can write:

+ () 2 ~ 2

This is the definition of the Hurst exponent H. For a price series exhibiting geometric random walk, H = 0.5. But

for a mean-reverting series, H < 0.5, and for a trending series, H > 0.5. As H decreases toward zero, the price

series is more mean reverting, and as H increases toward 1, the price series is increasingly trending; thus, H serves

also as an indicator for the degree of mean reversion or trendiness

Stationarity

Variance Ratio Test

Because of finite sample size, we need to know the statistical significance of an estimated value of H to be sure

whether we can reject the null hypothesis that H is really 0.5. This hypothesis test is provided by the Variance Ratio

test. It simply tests whether

( )

( 1 )

is equal to 1. The outputs of this test are h and pValue: h = 1 means rejection of the random walk hypothesis at

the 90 percent confidence level, h = 0 means it may be a random walk. pValue gives the probability that the null

hypothesis (random walk) is true

Mean Reversion

Half Life of Mean Reversion I

The statistical tests we described for mean reversion or stationarity are very demanding, with their requirements of

at least 90 percent certainty. But in practical trading, we can often be profitable with much less certainty. In this

section, we shall find another way to interpret the coefficient of the ADF Equation so that we know whether it is

negative enough to make a trading strategy practical, even if we cannot reject the null hypothesis that its actual

value is zero with 90 percent certainty in an ADF test. We shall find that is a measure of how long it takes

for a price to mean revert

To reveal this new interpretation, it is only necessary to transform the discrete time series Equation of ADF to a

differential form so that the changes in prices become infinitesimal quantities. Furthermore, we ignore the drift and

the lagged differences and end up with the Ornstein Uhlenbeck formula for a mean reveriting process:

= 1 + +

In the discrete form of this equation, the linear regression of against 1 gave us . This value

carries over to the differential form, but it also allows for an analytical solution for the expected value of :

= 0 exp 1 exp

10

Mean Reversion

Half Life of Mean Reversion II

Remembering that is negative for a mean-reverting process, this tells us that the expected value of the price

decays exponentially to the value / with the half-life of decay equals to log(2)/. This connection between a

regression coefficient and the half-life of mean reversion is very useful for algorithmic traders.

First, if we find that is positive, this means the price series is not at all mean reverting, and we shouldnt

even attempt to write a mean-reverting strategy to trade it.

Second, if is very close to zero, this means the half-life will be very long, and a mean-reverting trading

strategy will not be very profitable because we wont be able to complete many round-trip trades in a given

time period.

Third, also determines a natural time scale for many parameters in our strategy. For example, if the half life

is 20 days, we shouldnt use a look-back of 5 days to compute a moving average or standard deviation for a

mean-reversion strategy. Often, setting the lookback to equal a small multiple of the half-life is close to

optimal, and doing so will allow us to avoid brute-force optimization of a free parameter based on the

performance of a trading strategy

11

Mean Reversion

Trading Mean Reversion

Once we determine that a price series is mean reverting, and that the half life of mean reversion for a price series is

short enough for our trading horizon, we can easily trade this price series profitably using a simple linear strategy:

determine the normalized deviation of the price (moving average divided by the moving standard deviation of the

price) from its moving average, and maintain the number of units in this asset negatively proportional to this

normalized deviation

The look-back for the moving average and standard deviation can be set to equal the half-life

You might wonder why it is necessary to use a moving average or standard deviation for a mean-reverting strategy

at all. If a price series is stationary, shouldnt its mean and standard deviation be fixed forever? Though we usually

assume the mean of a price series to be fixed, in practice it may change slowly, e.g. due to changes in the economy

or corporate management. As for the standard deviation, recall that the Hurst exponent equation implies even a

stationary price series with 0 < H < 0.5 has a variance that increases with time, though not as rapidly as a

geometric random walk. So it is appropriate to use moving average and standard deviation to allow ourselves to

adapt to an ever-evolving mean and standard deviation, and also to capture profit more quickly

12

Cointegration

Cointegrated Augmented Dickey Fuller Test

Unfortunately, most financial price series are not stationary or mean reverting. But, fortunately, we are not confined

to trading those prefabricated financial price series: We can proactively create a portfolio of individual price series

so that the market value (or price) series of this portfolio is stationary. This is the notion of cointegration: If we can

find a stationary linear combination of several non-stationary price series, then these price series are called

cointegrated. The most common combination is that of two price series: We are long one asset and simultaneously

short another asset, with an appropriate allocation of capital to each asset.

Why do we need any new tests for the stationarity of the portfolio price series, when we already have the trusty

ADF and Variance Ratio tests for stationarity? The answer is that given a number of price series, we do not know a

priori what hedge ratios we should use to combine them to form a stationary portfolio

Just because a set of price series is cointegrating does not mean that any random linear combination of them will

form a stationary portfolio. But pursuing this line of thought further, what if we first determine the optimal hedge

ratio by running a linear regression fit between two price series, use this hedge ratio to form a portfolio, and then

finally run a stationarity test on this portfolio price series? This is essentially what the CADF test does

13

Cointegration

Johansen Test for Cointegration

In order to test for cointegration of more than two variables, we need to use the Johansen test. To understand this

test, lets generalize the discrete version of the ADF equation to the case where the price variable y(t) are actually

vectors representing multiple price series, and the coefficients and are actually matrices. We will assume t = 0

for simplicity. Using English and Greek capital letters to represent vectors and matrices respectively, we can rewrite

the ADF equation as:

= 1 + + 1 1 + + +

Just as in the univariate case, we do not have cointegration if = 0. Lets denote the rank of as r, and the

number of price series n.

The number of independent portfolios that can be formed by various linear combinations of the cointegrating price

series is equal to r. The Johansen test will calculate r for us in two different ways, both based on the eigenvector

decomposition of . One test produces the so-called trace statistic, and the other one produces the eigen statistic.

We do not need to worry what they are exactly, since many programming packages will provide critical values for

each statistic to allow us to test whether we can reject the null hypotheses that r = 0 (no cointegrating relationship).

As a useful by-product, the eigenvectors found can be used as our hedge ratios for the individual price series to

form a stationary portfolio.

14

Mean reversion means that the change in price is proportional to the difference between the mean price and the

current price. Stationarity means that prices diffuse slower than a geometric random walk

The ADF test is designed to test for mean reversion. The Hurst exponent and Variance Ratio tests are designed to

test for stationarity

Half-life of mean reversion measures how quickly a price series reverts to its mean, and is a good predictor of the

profitability or Sharpe ratio of a mean reverting trading strategy when applied to this price series

One can combine two or more non-stationary price series to form a stationary portfolio, these price series are

called cointegrating. Cointegration can be measured by either CADF test or Johansen test

The eigenvectors generated from the Johansen test can be used as hedge ratios to form a stationary portfolio out of

the input price series, and the one with the largest eigenvalue is the one with the shortest half-life

Questions?

15

Sources

Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernest Chan

The Mathematics of Money Management: Risk Analysis Techniques for Traders by Ralph Vince

16

Algorithmic Trading

Session 6

Trade Signal Generation IV

Momentum Strategies

Oliver Steinki, CFA, FRM

Outline

Introduction

What is Momentum?

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

moving average strategy, the crossing of the shorter running moving average over the

longer running moving average triggers when to trade. Next to long and short, the signal

can also be neutral (do nothing). Using moving averages to generate long/short trading

signals is an example choice of how to trade

Sessions 3 6 deal with the question of deciding when and how to trade

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Session 4: Backtesting

Session 5: Mean Reversion Strategies

Todays Session 6: Momentum Strategies

PERFORMANCE

ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

Introduction

Mean Reversion vs. Momentum

Trading strategies can be profitable only if securities prices are either mean-reverting or trending.

Otherwise, they are random walking, and trading will be futile. If you believe that prices are mean reverting and

that they are currently low relative to some reference price, you should buy now and plan to sell higher later.

However, if you believe the prices are trending and that they are currently low, you should (short) sell now and plan

to buy at an even lower price later.The opposite is true if you believe prices are high

Academic research has indicated that stock prices are on average very close to random walking. However,

this does not mean that under certain special conditions, they cannot exhibit some degree of mean reversion or

trending behaviour. Furthermore, at any given time, stock prices can be both mean reverting and trending

depending on the time horizon you are interested in. Constructing a trading strategy is essentially a matter of

determining if the prices under certain conditions and for a certain time horizon will be mean reverting or

trending, and what the initial reference price should be at any given time

Momentum

What is Momentum?

Academics sometimes classify momentum in asset prices into two types: time series momentum and crosssectional momentum. Time series momentum is very simple and intuitive: past returns of a price series are

positively correlated with future returns. Cross-sectional momentum refers to the relative performance of a price

series in relation to other price series: a price series with returns that outperformed other price series will likely

keep doing so in the future and vice versa

Momentum Tests

How Can We Discover Momentum?

Time series momentum of a price series means that past returns are positively correlated with future returns. It

follows that we can just calculate the correlation coefficient of the returns together with its p-value

One feature of computing the correlation coefficient is that we have to pick a specific time lag for the returns.

Sometimes, the most positive correlations are between returns of different lags. For example, 1-day returns might

show negative correlations, while the correlation between past 20-day return with the future 40-day return might

be very positive. We should find the optimal pair of past and future periods that gives the highest positive

correlation and use that as our look-back and holding period for our momentum strategy

Alternatively, we can also test for the correlations between the signs of past and future returns. This is appropriate

when all we want to know is that an up move will be followed by another up move, and we dont care whether the

magnitudes of the moves are similar

If we are interested instead in finding out whether there is long-term trending behaviour in the time series without

regard to specific time frames, we can calculate the Hurst exponent together with the Variance Ratio test to rule

out the null hypothesis of a random walk

Momentum Tests

Augmented Dickey Fuller Test

If a price series is trending, then the current price level will tell us something about what the prices next move will

be: If the price level is higher than the previous price level, the next move should also be an upward move; if the

price level is lower than the previous price level, the next move should also be a downward move. The ADF test is

based on just this observation.We can describe the price changes using a linear model:

= 1 + + + 1 1 + + +

The ADF test will find out if = . If the hypothesis = 0 can be rejected, it means that the next move of the

asset is dependent on the current level and therefore not random

The statisticians Dickey and Fuller described the distribution of this test statistic and tabulated the critical values for

us, so we can look up for any value of /SE() whether the hypothesis can be rejected at, say, the 95 percent

probability level

Since we expect momentum, /SE() has to be positive, and it has to be more positive than the critical value for

the hypothesis to be rejected. The critical values themselves depend on the sample size and whether we assume that

the price series has a non-zero mean / or a steady drift t/. Most practitioners assume the drift term to be

zero

Momentum Tests

Hurst Exponent

Intuitively speaking, a trending price series means that the prices diffuse from its initial value faster than a geometric

random walk would. Mathematically, we can determine the nature of the price series by measuring this speed of

diffusion.The speed of diffusion can be characterized by the variance

= + ()

random walk, we know that

+ ()

The means that this relationship turns into an equality with some proportionality constant for large , but it

may deviate from a straight line for small . But if the (log) price series is mean reverting or trending (i.e., has

positive correlations between sequential price moves), the last equation wont hold. Instead, we can write:

+ () 2 ~ 2

This is the definition of the Hurst exponent H. For a price series exhibiting geometric random walk, H = 0.5. But

for a mean-reverting series, H < 0.5, and for a trending series, H > 0.5. As H decreases toward zero, the price

series is more mean reverting, and as H increases toward 1, the price series is increasingly trending; thus, H serves

also as an indicator for the degree of mean reversion or trendiness

Momentum Tests

Variance Ratio Test

Because of finite sample size, we need to know the statistical significance of an estimated value of H to be sure

whether we can reject the null hypothesis that H is really 0.5. This hypothesis test is provided by the Variance Ratio

test. It simply tests whether

( )

( 1 )

is equal to 1. The outputs of this test are h and pValue: h = 1 means rejection of the random walk hypothesis at

the 90 percent confidence level, h = 0 means it may be a random walk. pValue gives the probability that the null

hypothesis (random walk) is true

Time Series Strategies

For a certain future, if we find that the correlation coefficient between a past return of a certain look-back and a

future return of a certain holding period is high, and the p-value is small, we can proceed to see if a profitable

momentum strategy can be found using this set of optimal time periods

Why do many futures returns exhibit serial correlations? And why do these serial correlations occur only at a fairly

long time scale? The explanation often lies in the roll return component of the total return of futures

Example 6.1 (file TU_mom) results in the following return profile btw. June 1, 2004 and May 11, 2012:

0.05

Sharpe: 1

0.04

0.03

0.02

0.01

-0.01

100

200

300

400

500

600

700

800

900

10

Extracting Roll Returns

If the roll return is negative (contango future curve), buy the underlying asset and short the futures

If the roll return is positive (backwardation future curve), short the underlying asset and buy the futures

This will work as long as the sign of the roll return does not change quickly

However, the logistics of buying and especially shorting the underlying asset is not simple, unless an exchangetraded fund (ETF) exists that holds the asset

11

News Sentiment as a Fundamental Factor

With the advent of machine-readable, or elementized, newsfeeds, it is now possible to programmatically capture

all the news items on a company, not just those that fit neatly into one of the narrow categories such as earnings

announcements or merger and acquisition activities

Natural language processing algorithms are now advanced enough to analyse the textual information contained in

these news items, and assign a sentiment score to each news article that is indicative of its price impact on a stock

The success of these strategies also demonstrates very neatly that the slow diffusion of news is one cause of

momentum

12

Mutual Funds Asset Fire Sale and Forced Purchases

Mutual funds experiencing large redemptions are likely to reduce or eliminate their existing stock positions. This is

no surprise since mutual funds are typically close to fully invested, with very little cash reserves

Also, funds experiencing large capital inflows tend to increase their existing positions rather than using the

additional capital to invest in other assets, perhaps because new investment ideas do not come by easily

Assets disproportionately held by poorly performing mutual funds facing redemptions therefore experience

negative returns. Furthermore, this asset fire sale by poorly performing mutual funds is contagious

Hence, momentum in both directions for the commonly held assets can be exploited

13

Summary

Futures exhibit time series momentum mainly because of the persistence of the sign of roll returns

If you are able to find an instrument (e.g., an ETF or another future) that cointegrates or correlates with the spot

price or return of a commodity, you can extract the roll return of the commodity future by shorting that

instrument during backwardation, or buying that instrument during contango

Profitable strategies on news sentiment momentum show that the slow diffusion of news is one cause for stock

price momentum

The contagion of forced asset sales and purchases among mutual funds contributes to stock price momentum

14

Opening Gap Strategy

Gap measures the difference in opening price relative to last closing price. For example a stock closing on Friday at

USD 100 and reopening on Monday at USD 95 has an opening gap of -5 USD

Whats special about the overnight or weekend gap that sometimes triggers momentum? The extended period

without any trading means that the opening price is often quite different from the closing price

Hence stop orders set at different prices may get triggered all at once at the open. The execution of these stop

orders often leads to momentum because a cascading effect may trigger stop orders placed further away from the

open price as well

Also, the gap could result from significant events that occurred overnight

15

News Driven Momentum Strategy

As momentum is driven by the relatively slow diffusion of news, one can benefit from the first few days, hours, or

even seconds after a newsworthy event. For example, ECB press conferences are aired with 15sec. delay and only

subscribers of special services can see it live to profit from any significant announcements

Earnings announcements are another example of news driven intraday momentum. It is surprising that it still

persists, although the duration of the drift has shortened

Earnings guidance, analyst ratings and recommendation changes on a stock specific level as well as macroeconomic

indicators such as housing and unemployment numbers, consumer confidence or purchasing manager indices are

other examples of momentum creating news

16

Index Composition and Leveraged ETFs

Rebalancings of major indices results in intraday momentum due to ETF trading activity to mirror these changes in

index composition. For example, if a stock joins the MSCI World index, all ETFs as well as funds benchmarked to

this index have to buy this stock. This momentum usually last only for a few hours on the announcement as well as

the implementation date as there are now quite some players trying to anticipate and frontrun index composition

changes

The sponsors (issuers) of leveraged ETFs experience a similar issue which can create momentum. Lets assume

there is a three times leveraged ETF mirroring a basket of stocks. If a constituent stocks goes up, the ETF sponsor

has to buy it to hold the leverage ratio constant

17

Summary

Breakout momentum strategies involve a price exceeding a trading range. The opening gap strategy is a breakout

strategy that works for some futures and currencies. Breakout momentum may be caused by the triggering of stop

orders

Many kinds of corporate and macroeconomic news induce short-term price momentum

Index composition changes induce momentum in stocks that are added to or deleted from the index

Rebalancing of leveraged ETFs near the market close causes momentum in the underlying index in the same

direction as the market return from the previous close

18

Time-series momentum refers to the positive correlation of a price series past and future returns

Cross-sectional momentum refers to the positive correlation of a price series past and future relative returns, in

relation to that of other price series in a portfolio

Lagged correlation of prices or returns, the ADF test, the Hurst exponent and Variance Ratio test can be used to

test for momentum

Different strategies apply to inter and intraday techniques. More and more sophisticated traders result in a reduced

time to exploit the momentum created by significant news, e.g. the speed of news diffusion is increasing

Questions?

19

Sources

Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernest Chan

The Mathematics of Money Management: Risk Analysis Techniques for Traders by Ralph Vince

20

Algorithmic Trading

Session 7

Trade Implementation I

Orders

Oliver Steinki, CFA, FRM

Outline

Introduction

Market Orders

Limit Orders

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

Trade Implementation happens after the Signal Generation step has triggered a buy or

sell signal. It determines how the order is structured, e.g. position size and limit levels. In

advanced strategies, it can also take into account cross correlation with other portfolio

holdings and potential portfolio constraints

Sessions 7 9 deal with the question of sizing and executing trades, incl. exit

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Session 8: Algorithmic Execution

Session 9: Transaction Costs

PERFORMANCE

ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

Introduction

Orders

Orders represent instructions how to execute trades. They allow traders to communicate their detailed

requirements, from the type of order chosen to a wide range of additional conditions and directions.

The two main order types are market and limit orders. They are exact opposites in terms of liquidity provision:

market orders are filled immediately at the best available price, but demand liquidity. Limit orders provide

liquidity and act as standing orders with inbuilt price limits, which must not be breached

Several conditions might be applied to each order to control additional execution features:

Market Orders

Market orders are instructions to trade a given quantity at the best price possible. The focus is on completing the

order with no specific price limit, so the main risk is the uncertainty of the ultimate execution price

Market orders demand liquidity, a buy market order will try to execute at the ask price, whilst a sell order will try

to execute at the bid price. The immediate cost of this is half the bid-ask spread

For orders that are larger than the current best bid or ask size, most venues allow market orders to walk the

book. If they cannot fill completely from the top level of the order book, they then progress to the next price

level of the book. If the order still cannot be completed, some venues cancel it (e.g. LSE), whereas others leave

the residual market order in the book (e.g. Euronext)

Hence, the execution price achieved with a market order depends on both the current market liquidity and the

size of the market order

Limit Orders

Limit orders are instructions to trade a given quantity at a specified price or better. A buy order must execute at

or below the limit price, whereas a sell order must execute at or above it.

Limit orders will try to fill as much of the order as they can, without breaking the price limit. If there are no

orders that match at an acceptable price, then the order is left in place on the order book until it expires or is

cancelled. If the order is partially executed, the residual quantity will remain on the order book. This provides

liquidity as other traders can see that someone is willing to trade at a given price and quantity

Hence, limit orders are quite versatile. They can be used with an aggressive limit price, in which case they act like

a market order demanding liquidity. The firm price limit gives added price protection compared to a market

order, although there is the risk of failing to execute. Alternatively, limit orders may be issued with more passive

limits, such as when trying to capture gains from future price trends or mean reversion

The main risk with limit orders is the lack of execution certainty. The market price may never reach our limit or

even if it does, it may still not be executed since other orders may have time priority

Orders that are placed at the market correspond to buys with a limit of the best bid or sells with a limit at the

best ask. The traders who placed these orders are said to be making the market. Whilst the most passively priced

limit orders are termed behind the market. Their prices mean that they are likely to remain on the order book as

standing limit orders until the best bid or ask price moves closer to their limit

6

Overview

Order instructions are conditions that cater for the various requirements for a wide range of trading styles. They

allow control over how and when orders become active, how they are filled and can even specify where (or to

whom) they are sent to

These optional order instuctions can be split according to the following criteria, which we will investigate in more

detail on the next slides:

Duration

Auction / Crossing Session

Fill Instructions

Preferencing

Routing

Linking

Duration

Generally, orders are assumed to be valid from their creation until they are completely filled or cancelled, or it

reaches the end of the current trading day. These orders are know as good for the day (GFD) orders.

Good til date (GTD)

Good till cancel (GTC)

Good after time/date (GAT)

A GTD order remains valid until the close of trading on the specified date. Variants of GTD orders include GTW

(good this week) and GTM (good this month) orders

A GTC order means the order should stay active until cancelled or until the instrument on which the order was

valid expires (mainly applicable to derivatives)

A GAT order is less common and basically only starts at a specific date and time in the future

Auction / Crossing Session Instructions

Auction / Session instructions are used to mark an order for participation in a specific auction, or trading either at

the open, close or intraday

Like normal market orders, auction market orders are intended to maximize the probability of execution, since in

the auction matching they will always have price priority. Whereas auction limit orders will only be executed if

the auction price equals or is better than their limit price

On-Open orders may be submitted during the pre-open period for participation in the opening auction. If the

matching volume is sufficient, then MOO (market on open) orders will execute at the auction price. For any

unfilled MOO orders, some venues convert them to limit orders at the auction prices, whilst other venues just

cancel them. MOC (market on close) order will execute at the close price, given sufficient matching volume.

Any unfilled orders will usually be cancelled

LOO (limit on open) and LOC (limit on close) orders will only execute given sufficient matching volume and

an auction price equal or better than the specified limit

Fill Instructions

Fill instructions were traditionally used to minimize the clearance and settlement costs of trades. Nowadays, they

are most often used as parts of liquidity seeking strategies.

Immediate or Cancel (IOC): This order means any portion of the order that cannot execute immediately

agains existing orders will be cancelled

Fill or Kill (FOK): A FOK order ensures that the order either executes immediately in full or not at all. It is

basically an IOC order combined with a 100% completion requirement.

All or None (AON): The AON instruction enforces a 100% completion requirement on an order. Unlike

FOK, there is no requirement for immediacy

Minimum Volume (MV): An MV instruction ensures that the order only fills if the quantity is sufficient.

Must be Filled (MBF): Unlike the other fill instructions, failure to fully execute is not an option for MBF

orders. MBF orders are hence treated as market orders and as they are often used to cover corresponding

option positions, short sale constraints usually dont apply

10

Preferencing and Directed Instructions

Order preferencing and directed instructions permit bilateral trading, since they direct orders to a specific broker

or dealer. One specificity with both directed and preferenced orders is that they bypass any execution priority

rules. So other orders which might have time priority will lose out to the directed market maker

Preferenced orders prioritise a specific market maker. On some exchanges they behave like FOK orders, being

cancelled if the chosen market maker does not quote at the best price

Directed orders are routed to a specific market maker or dealer who may accept or reject them. On some

exchanges, market makers offer price improvement for directed orders

11

Routing Instructions

Execution venues have often catered for additional routing instructions for orders. Thus providing a gateway

service that allows orders to be routed to other venues as well as handling them locally. This is especially

applicable for the order protection rule in the US, where it requires a venue or broker to pass on orders elsewhere

to achieve the best prices.

Do not route: This instruction ensures that the execution venue will handle the order locally and not route it

to another venue

Directed routing: This instruction provides an associated destination for where the order should be routed to.

Effectively, the host venue acts as a gateway to route such orders on to their chosen destination. The

advantage of this approach is that orders may be routed to venues for which we do not have a membership,

although the host venue will levy routing fees for such orders

Inter Market Sweeps: Such an order sweeps or walks down the order book at a single venue. It means that

the order will not be routed to other venues and hence be filled where we specify. This gives better control

over how and where our orders are placed, something important if we have similar orders on across multiple

venues

12

Linking Instructions

A one cancels other (OCO) instruction may be used to make two orders mutually exclusive, often used to close

out positions. For example, we could have a sell order and a stop loss order on for a given instrument, together

with an OCO instruction. Hence, if one of the two orders is filled, the other one would be automatically

cancelled

A one triggers other (OTO) order links a supplementary order to a main order. For example, only if a certain buy

order is filled, will the corresponding stop order become active

13

Overview

Conditional orders base their validity on a set condition, often the market price. Only when the condition is met

will it result in an actual order being placed. Thus, stops and contingent orders only become active when a

threshold price is breached

Trailing stop orders are similar, although they use a dynamic threshold

Contingent / if touched orders are similar, yet the opposite of stop orders. There are as well two types, market if

touched or limit if touched orders.

Hidden, undisclosed or non-displayed orders allow traders to participate in the market place without giving away

their position / trade size

14

Stop Orders

Stop orders are contingent on an activation or stop price. Once the market price reaches or passes this point, they

are transformed into active market orders. In continuous trading, the price being tracked is generally the last

traded price, whilst in an auction it is usually the clearing price. Activation occurs for buys when the market price

hits the stop price or moves above, whilst for sells it is when the market price hits or drops below the stop price

They are referred to as stop loss orders. As sells, they are generally used as a safety net to protect profits by

closing out long positions should the market move against us and drop below the stop level, and vice versa.

Note that the market order generated by a stop does not guarantee anything on the actual price achieved. Hence,

if there are very significant news, you might be executed way worse than your stop level as they are only activated

when the market prices becomes unfavorable.

Stop Limit orders replace the market order once the stop is reached with a limit order. As usual, while these

orders offer price protection, they do not offer execution guarantee

Whilst stop orders are a useful tool, they can also have considerable market impact, in particular in times of

market turbulence. Upon activation, all stop orders tend to accelerate the price trend that triggered them

15

Trailing Stop and Contingent Orders

A stop orders uses an absolute price, whereas for a trailing stop order the stop price follows (or trails) favourable

moves in market price

For a trailing stop sell order, as the market price rises, the trailing stop price will rise by a similar amount.

However, when the market price falls, the stop price does not change. For a trailing stop buy order, as the market

price drops, the trailing stop price will drop by a similar amount. Again, if the market price rises, the stop price

level doesnt change

Contingent, or if-touched orders are effectively the opposite of stop orders. For FX, they are often called entry

orders as they are mainly used to enter positions

As with stops, there are two types, limit-if-touched and market-if-touched. The main difference to a normal

market or limit order is that it is hidden from the order book until activated

16

Hidden Orders

Hidden, undisclosed or non-displayed orders are used by traders who do not want to show their trade size.

Hidden orders do not appear on the order book and are not allowed on all exchanges. If allowed, they are usually

given lower priority to normal orders with the same price limit, even if they have been entered earlier.

An iceberg order comprises of a small visible peak and a significantly larger hidden volume. The peak (or display

volume) is customizable, although some venues require minimum sizes. The visible order cannot be distinguished

from a normal order. Each time the visible order is fully executed, the next peak will be displayed. Hence, each

displayed order has normal time priority within the order book whilst the hidden volume has only price priority

17

The two main order types are limit and market orders

Additional conditions can be applied to each order to control additional execution features:

Conditional, contingent, and hidden orders can be used for more advanced entry and exit rules

Questions?

18

Sources

19

Algorithmic Trading

Session 8

Trade Implementation II

Algorithmic Execution

Oliver Steinki, CFA, FRM

Outline

Introduction

Algorithmic Execution

Opportunistic Algorithms

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

Trade Implementation happens after the Signal Generation step has triggered a buy or

sell signal. It determines how the order is structured, e.g. position size and limit levels. In

advanced strategies, it can also take into account cross correlation with other portfolio

holdings and potential portfolio constraints

Sessions 7 9 deal with the question of sizing and executing trades, incl. exit

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Todays Session 8: Algorithmic Execution

Session 9: Transaction Costs

PERFORMANCE

ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

Introduction

Review: Algorithmic Trading - Areas of Applications

Algorithmic Execution: Use algorithms to search/discover fragmented liquidity pools to optimize execution

via complex / high frequency order routing strategies. Profit comes from improved prices and reduced market

impact

Example: Order routing to dark pools to improve execution price, % of volume orders to reduce market

impact

This is what we discuss today

Market Making: Supply the market with bid ask quotes for financial securities. Ensure the book respects

certain constraints such as delta profile or net position. Profit comes mainly from clients trading activity, hence

the bid-ask spread. Also known as flow trading or sell side. Main risk comes from market moves against position if

net position/Greeks are not perfectly hedged

Example: A broker offers to sell a financial security at the ask and to buy at the bid to earn the spread

Trade Signal Generation: Design proprietary strategies to generate profits by betting on market directions.

Profit comes from winning trades. Also known as proprietary trading or buy side. Main risk is that market does

not move as expected/back tested and strategy becomes unprofitable

Example: Buy/sell security when moving averages cross each other

This is what we discuss in general

4

Introduction

Algorithmic Execution

An algorithm is a set of instructions to accomplish a given task. In the context of algorithmic execution, this means

that a trading algorithm simply defines the steps required to execute an order in specific ways

Impact Driven

Cost Driven

Opportunistic

Impact driven algorithms try to to minimize the overall market impact, hence they try to reduce the effect trading

has one the assets price. For example, larger orders will be split into smaller ones, trading them over a longer time

period.

Cost driven algorithms aim to reduce overall trading costs. Hence, they have to incorporate market impact, timing

risk and even price trends. Hence, implementation shortfall is an important performance benchmark for these kind

of algorithms.

Opportunistic algorithms take advantage whenever they perceive favorable market conditions. These algorithms

are generally price or liquidity driven or involve pair/spread trading

5

Algorithmic Execution

Generic Algorithm Parameters

Execution algorithms are controlled by a range of parameters, which provide the algorithm with limits or

guidelines. These parameters can be split into generic and specific. E.g., specific parameters are used to define how

much a volume weighted average price (VWAP) order may deviate from the historical volume profile. Generic

parameters represent common details of execution algorithms and are listed below:

Start / End Times: Execution algorithms usually accept specific start and end times, instead of just

duration instructions like GTC. Some algorithms even derive their own optimal trading horizon, especially

the cost driven ones. If these criteria are not entered, default values such as end of day as end time are used

Duration: Some vendors do not work with end times and use a duration parameter instead

Execution Style: This can be categorized into aggressive, passive or neutral trading and is a question of

execution certainty vs. price certainty. The more aggressive, the higher the execution certainty at the

expense of cost / performance

Limit: This feature offers price certainty like a normal limit order for algorithms without inbuilt price limits

Volume: This feature tells the algorithm a certain percentage of market volume to trade (either min. or

max.)

Auction: This feature is used to specify if the algorithm is allowed to participate in auctions and if so at

which percentage?

6

Overview

Impact driven algorithms evolved from simple order slicing strategies. By splitting larger orders into smaller child

orders, they try to reduce the impact the trading has on the assets price, and so to minimize overall market

impact costs

The average prices based algorithms, namely time weighted average price (TWAP) and volume weighted average

price (VWAP), represent the first generation of impact driven algorithms. Although intended to minimize impact

costs, their main focus is their respective benchmarks. These are predominantly schedule based algorithms and so

they track statistically created trajectories with little or no sensitivity to conditions such as price or volume. Their

aim is to completely execute the order within the given timeframe, irrespective of market conditions

The natural progression from these static first generation algorithms has been the creation of more dynamic

methods, which resulted in a gradual shift to more opportunistic methods

Time Weighted Average Price

A time weighted average price (TWAP) order is benchmarked to the average price, which reflects how the assets

market price has evolved over time. Therefore, execution algorithms that attempt to match this benchmark are

usually based on a uniform time-based schedule

The basic mechanism behind a TWAP order is based on time slicing. For example, an order to buy 1000 shares

could be split into 10 child orders of 100 shares each every 5 minutes. Hence, the trading patterns are very

uniform and independent of price and volume

TWAP orders can suffer poor execution due to their rigid adherence to the time schedule, especially if the price

becomes unfavorable or the available liquidity suddenly drops

Alternatively, we can use the linear nature of the target completion profile to adopt a more flexible trading

approach. At any given time, we can determine the target quantity the order should have achieved, e.g. 25% of

the order should be completed after 25min. in the above mentioned example. So instead of following a very

deterministic approach, we could adopt a slightly more random approach by comparing the actual progress to the

planned schedule. This allows us to vary trade frequency and size and makes the TWAP schedule less predictable

for other market participants to spot

Volume Weighted Average Price

The volume weighted average price (VWAP) benchmark for a given time span is the total traded value divided be

the total traded quantity. As a benchmark, it rapidly became very popular as it is easy to calculate and a fair

reflection of market conditions

The basic mechanism behind a VWAP order is based on the overall turnover divided by the total market volume.

Given n trades in a day, each with a specific price pn and size vn VWAP is calculated as:

=

While TWAP orders are simply a matter of trading regularly throughout the day, VWAP orders also need to trade

in the correct proportions. As we do not know the trading volume beforehand, we do not know these proportions

in advance. A common approach to mitigate this problem is the use of historical volume profiles of the asset as a

proxy. This is used as the basis for most VWAP execution algorithms

Hence, throughout the day, the execution algorithms just needs to place sufficient orders in each interval to keep

up with the target execution profile based on historic data

Percentage of Volume

Percentage of volume (POV) algorithms are go along orders with the market volume. They are also known as

volume inline, participation, target volume or follow algorithms. For example a POV order of 10% for a stock

with 1m. shares daily turnover should result in an execution of 100k shares

The basic mechanism behind POV is a dynamic adjustment based on market volume and hence different to TWAP

and VWAP orders, which follow predetermined trading schedules. The algorithm tries to participate in the

market in proportion to the market volume. Note that there is no relationship between the trading pattern and the

market price, the target trade size is solely driven by market volume

The POV order is similar to the VWAP if historical and actual trading patterns are similar. Although POV orders

are more dynamic than VWAP orders, they still cannot predict market volume

A common risk factor of POV orders is the potential to drive up or down prices if many traders have POV orders

on. One way to protect against such situations are firm price limits applied to POV orders, as they usually come

without inbuilt price sensitivity

10

Minimal Impact

Minimal impact algorithms represent the next logical progression from VWAP and POV execution algorithms.

Rather than seeking to track a market driven benchmark, they focus solely on minimizing market impact. Signaling

risk is an importing consideration for the algorithms we have seen so far. It describes the risk of potential losses

due to information that our trading pattern relays to the other market participants and depends on our trading size

and the assets liquidity

The basic mechanism behind minimal impact algorithms is therefore to route orders to dark pools, brokers

internal crossing networks as well as using hidden order types. As actual hit ratios on some dark pools can be low,

often a proportion of the order is left as VWAP or POV order on the main venue to ensure a minimum level of

execution

Specific parameters of minimal impact orders therefore include the visibility and the must be filled criteria.

While the visibility criteria determines how much of the order is actually displayed on the main venue, the must

be filled criteria determines which percentage of the order has to be filled. As the minimal impact algorithm is

focused on reducing cost at the risk of failing to fully execute, it might be more appropriate to use a cost based

algorithm if one wants to guarantee full execution

11

Overview

Cost driven algorithms seek to reduce the overall transaction costs. As we have seen in session 3, these are more

than commissions and the bid-ask spread, they also include implicit costs such as market impact and slippage

We have learned that market impact might be reduced by time slicing (TWAP orders). However, this exposes

orders to a much greater timing risk, especially for volatile assets. Therefore, cost driven algorithms also target to

reduce timing risk

In order to minimize overall transaction costs, we need to strike a balance between market impact and timing risk.

Trading too aggressively may result in considerable market impact, while trading too passively incurs timing risk.

Furthermore, we must know the investors level of urgency or risk aversion to strike the right balance

Implementation shortfall represents a purely cost driven algorithm. It seeks to minimize the shortfall between the

average trade price and the assigned benchmark, which should reflect the investors decision price

Adaptive Shortfall algorithms are just more opportunistic derivatives of implementation shortfall. They are

generally more price sensitive, although liquidity driven variants also start to appear

Market on close (MOC) algorithm aim to beat an undetermined benchmark, the future closing price. Unlike

TWAP or VWAP where the average evolves through the day, it is harder to predict where the closing price will

actually be. It is the reverse of implementation shortfall: instead of determining an optimal end time, we need to

calculate an optimal starting time

12

Implementation Shortfall

Implementation shortfall (IS) represent the difference between the price at which the investor decides to trade and

the average execution price that is actually achieved. The decision price is used as the benchmark, although often it

is not specified and instead the mid price when the order reaches the broker is used as default

The goal of IS algorithms is to minimize the difference between average execution price and decision price. To

strike the right balance between market impact and timing risk, it usually means that the algorithm tends to take

only as long as necessary to prevent significant market impact

To determine the optimal trade horizon the algorithm needs to account for factors such as order size and time

available for trading. It must also incorporate asset specific information such as liquidity and volatility.

Additionally, it must also take into account the investors urgency or risk aversion. Quantitative models are then

used to derive the optimal trade horizon based on the factors mentioned. Generally, a shorter trade horizon is due

to:

Assets with high volatility, also those with lower bid ask spreads

High risk aversion

Smaller order size, so less potential market impact

Having calculated the optimal trade horizon, a static algorithm will then determine the trading schedule, whilst

the dynamic one will determine the most appropriate participation rate. Since both versions have a pre

determined benchmark, they will both favor to trade more at the beginning of an order when the price is still

close to the benchmark

13

Adaptive Shortfall

Adaptive shortfall (AS) represents a relatively recent subclass of algorithms derived from implementation shortfall.

The adaptive moniker refers to the addition of adaptive behavior, mostly in reaction to the market price. Hence,

AS algorithms behave more opportunistic than IS algorithms. An aggressive adaptive algorithm trades more

aggressively with favorable prices and less when they become adverse. The opposite applies for passive AS orders.

AS algorithms are built upon IS algorithms, so there basic behavior is the same. However, the AS algorithm

dynamically adjusts in real time based on current market conditions. Initially, a baseline target for volume

participation may be determined based on the estimated optimal trade horizon. During trading, the adaptive

portion is then used to modify this rate. For an aggressive AS algorithm, the participation rate would be increased

if market prices are favorable compared to the benchmark, for passive AS algorithms the participation rate would

be decreased.

As the only parameter not needed for IS algorithms, the user has to specify one additional parameter for AS

algorithms, the adaption type: either passive or aggressive

14

Market on Close

The close price is often used for marking to market, calculating net asset values and daily PnLs. Hence, many

market participants are interested in the closing price as the benchmark although trading at the close can be costly.

Researchers found that prices are more sensitive to order flow at the close. They also noted price reversals after

days with significant auction imbalances. While call auctions have helped to reduce end of day volatility, the

liquidity premium can still be considerable around the close

The main issue for MOC algorithms is the fact that the benchmark is unknown until the end of the trading day.

We cannot simply slice the order to try to match or beat the benchmark. We should also not start trading too

early, in order to avoid exposure to timing risk due to the variability in the closing price. However, trading too

late may result in significant market impact

Most MOC algorithms determine an optimal trading horizon using quantitative models, incorporating similar

factors as IS algorithms. As IS algorithms determine an optimal end time, MOC algorithms calculate an optimal

start time

In general, MOC algorithms have the same parameters as IS algorithms. However, they also allow specific

parameters for different risk aversion profiles, end time and auction participation. The auction

participation instruction specifies the minimum or maximum order size allowed to participate in the close auction

15

Opportunistic Algorithms

Overview

Opportunistic algorithms have evolved from a range of trading strategies. They all take advantage of favorable

market conditions, whether this is based on price, liquidity or another factor such as spread/ratio

Price inline algorithms are essentially based on an underlying impact driven strategy such as VWAP or POV. What

they add is price sensitivity, which enables them to modify their trading style based on whether the current market

price is favorable or not. So a focus on market impact has given way to a more opportunistic approach

Liquidity driven algorithms are an evolution of simpler rule based order routing strategies. The trading is driven

by the available liquidity, although cost is also a factor

As pair trading is effectively a market neutral strategy, market risk is less of a concern. Instead, the key driver is

when the spread or ratio between the assets is favorable

16

Opportunistic Algorithms

Price Inline

A price inline (PI) algorithm adapts to the market price in a similar way to how POV algorithms adjust to market

volume. A benchmark price is defined and trading is then altered based on how the market price compares to it.

Default value for the benchmark is the mid price at the time of order arrival. Similar to AS algorithms, the term

moneyness is sometimes used for favorable market conditions

A PI algorithm consists of a basic trading mechanism combined with the price adaptive functionality. Hence, it

could be based on a static VWAP or a more dynamic POV. The actual price adaption might track the difference

between benchmark and market price and tilt an aggressive PI algorithm to trade proportionally more shares when

market conditions are favorable. Using the example of a participation rate of a POV algorithm, the PI algorithm

would increase the participation rate for a buy order when the market price is below the benchmark price

Special parameters include adaption type (like in AS), participation rate (for algorithms based on POV) and

participation adjustment. This specifies how much to alter the participation rate for a given price move, for

example 5% for every 10 cents. Asymmetrical participation levels are also possible

17

Opportunistic Algorithms

Liquidity

Liquidity represents the ease of trading a specific asset, hence it has a considerable effect on overall transaction

costs. Originally, liquidity based trading simply meant making decisions based on the available order book depth,

rather than just the best bid and offer. In todays fragmented markets with many potential execution venues,

liquidity seeking has become more complicated

Liquidity is closely related to market depth and price. Therefore, a liquidity seeking algorithm will react strongest

when there is plenty of market depth combined with a favorable price. Instead of making the algorithm react to

market volume, one can create a market depth measure that reflects the volume available at a favorable price

point. Therefore, when market depth and price are favorable, the algorithm trades aggressively to consume

liquidity

Liquidity driven algorithms are often used in fragmented markets. Often, clients may want their orders to only

participate at specific venues and might or might not want to use the internal crossing network of the broker

Special parameters include a visibility and benchmark price instruction. While visibility determines how

much of the order is actually displayed at execution venues (similar to iceberg orders), the benchmark price is

used to decide when the market price is favorable enough to warrant participation

18

Opportunistic Algorithms

Ratio/Spread

Pair trading involves buying one asset while simultaneously selling another one. As a market neutral strategy, the

risks from each asset should hedge or offset each other and hence the strategy less affected by market wide moves.

Pair trading can be broken down into statistical arbitrage and merger (risk) arbitrage. Statistical arbitrage is based

on relative valuations and based on the assumption that the spread will revert to its mean. Risk arbitrage is more

equity specific and evolves around the probability of a merger happening

Statistical arbitrage spread trading algorithms focus on trading for a pre-determined benchmark, which is either

the spread between two assets or the ratio of their prices. A simple example is based solely on the spread between

two asset prices. When the difference exceeds a certain threshold, trading is activated. An alternative example

would use the price ratio as the trigger to trade

Risk arbitrage pairs can generally use the same approach as the statistical arbitrage ones. The trading strategy

would usually include selling the bidding company and buying the target company

Specific parameters include the spread (watch out if defined A-B or A/B), a legging indicator (if the orders have to

be executed in parallel) and a volume limit if one wants to limit the participation rate

19

A execution algorithm is simply a set of instructions used to execute an order. They can be broadly categorized into

three groups based on the target objectives.These are impact driven, cost driven or opportunistic

Impact driven algorithms seek to minimize the overall market impact costs, usually by splitting larger orders into

smaller child orders

Questions?

20

Sources

21

Algorithmic Trading

Session 9

Trade Implementation III

Transaction Costs

Oliver Steinki, CFA, FRM

Outline

Introduction

Pre-Trade Analysis

Post-Trade Analysis

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

sell signal. It determines how the order is structured, e.g. position size and limit levels. In

advanced strategies, it can also take into account cross correlation with other portfolio

holdings and potential portfolio constraints

Sessions 7 9 deal with the question of sizing and executing trades, incl. exit

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Session 8: Algorithmic Execution

Todays Session 9: Transaction Costs

PERFORMANCE

ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

Introduction

Transaction Costs

Each time an asset is bought or sold, transaction costs are incurred. They can have a significant impact on

investment returns. Therefore, it is important to both measure and analyze them in order to improve execution

Transaction costs can vary between 1bps to 250bps of the value traded, dependent on the asset class, transaction

size and broker used. This wide range is partly due to the different characteristics of each asset and order, but also

due to the different way transaction costs may be assigned

One of the most common ways to examine transaction costs has been to compare the actual performance of a

portfolio with its paper equivalent. A paper portfolio is simply a virtual portfolio traded at benchmark prices,

but without accounting for any costs

While transaction costs are inevitable, they can be minimized. Therefore, in order to maximize investment

returns, it is important to accurately measure transaction costs and to anlayze them to understand how and why

they occur

Introduction

Transaction Costs in the Investment Cycle

Historically, most of the early research on transaction costs focused on post-trade analysis. Though, over the last

few years, pre-trade analysis has become ever more important. In particular, algorithmic trading is often reliant on

pre-trade models to achieve a more cost efficient execution

Pre-Trade Analysis concentrates on estimating potential transaction cost. Hence it is a key input into the choice of

trading strategy and can have a substantial effect on the overall execution (and so investment) performance.

Liquidity analysis might also be used to identify the best strategies and venues for trading

Post-Trade analysis focuses on execution performance and measurement of transaction costs. It is essential for

understanding the effectiveness of both the investment ideas and their implementation. In turn, this performance

is an important consideration when new investment strategies are formulated. For example, an investment

opportunity worth 30bps may not be worth following up if previous transaction costs for similar orders have been

around this level

Introduction

Transaction Costs Example

We will use the example from the assigned reading during this session to compare the various components of

transaction costs

Investment decision @ pd

Pre-Trade Analysis

Overview

Pre-trade analysis is important to ensure that best execution is achieved. These analytics help investors or traders

make informed decisions about how best to execute a given order

Four types of information are key to trading strategy selection. These four are:

The liquidity and risk estimates highlight the expected difficulty of trading. The cost estimates give a reasonable

indication of what might be achieved. This is particularly important for algorithmic trading strategies as it gives an

idea how suitable an order is for a given strategy

Pre-Trade Analysis

Price Data

A wide range of price data is useful for pre-trade analytics. The current market bid / ask prices act as a baseline for

what we might achieve. The last traded price is also useful (especially for illiquid assets), since this may be

significantly different from the current quotes

The bid ask spread is seen as an estimate for the cost of immediacy. If immediate execution is desired a seller has to

sell at the bid and a buyer has to buy at the ask, incurring the spread as the cost of immediacy. A comparison to

historical bid ask spreads allows us to gauge whether the current spread is unusual

Price ranges, such as the difference between a days high and low, give an indication of the current price volatility.

Likewise, benchmarks such as todays opening price or last nights close are also useful. Trends may be reflected by

daily, weekly or even monthly percentage changes

Pre-Trade Analysis

Liquidity Data

Liquidity is closely related to transaction costs. Trading volume offers a simple way to rate the liquidity of an asset.

The average daily volume (ADV) is often calculated over a period of 14, 30, 90 or 360 calendar days. The

percentage of ADV represents the relative size of our order given the assets volume. For instance, anything less

than 20% should be achievable to trade within a normal trading day, whereas above not without market impact

The required trading horizon can be based on the ADV, together with factor representing our trading

participation rate:

=

For example, given an order size of 50k as in our example, an ADV of 1m, and a trading participation rate of 10%

leads to the following horizon:

=

50,000

= 0.5

1,000,000 10%

For such estimates to reliable, it is important that the actual trading volume behaves similar to the historical one.

This can be measure by the coefficient of variation (CV), based on the standard deviation of ADV. As trading

stability is inversely related to this coefficient, a high CV value implies sizable deviations from the historical volume

=

Pre-Trade Analysis

Risk Data

Volatility is a key variable for estimating how much risk we may be exposed to. It is based on the standard deviation

of price returns (not prices, this is a common mistake), often for the last 1, 3, 6 or 12 months. As we have seen

with the CV, a high volatility implies a considerable amount of timing risk. Therefore, the more volatile the asset,

the more aggressive trading strategies (hence liquidity demanding strategies) are generally used to counteract the

timing risk

Market risk could be measured using an assets beta, which is a measure of its sensitivity to market returns

(CAPM). A positive value means that the asset price moves in the same direction as the market whilst a negative

one means it behaves in a contrarian fashion. A beta of 1 means that the asset moves in line in direction and size

with the market. A beta above 1 signifies a more pronounced price response, whilst an asset with a beta of below 1,

e.g. 0.5, moves only half as much as the market

10

Pre-Trade Analysis

Transaction Cost Estimates

Transaction cost models generally provide an estimate for the overall cost as well as detailing major cost

components such as market impact and timing risk. We will investigate both in more detail later in this

presentation

The basis for most transaction cost models is the framework of Almgren and Chriss (2000), where they detailed the

optimal execution of portfolio transactions. They use random walk models to estimate the current market price in

terms of permanent market impact, price trending and volatility

In terms of asset selection, given two assets with similar expected returns it is logical to trade the one that has the

lower expected transaction costs. Exactly the same applies for comparing different trading strategies, one should

use the one with the lowest expected transaction costs. Although detailed pre-trade analysis is required, historical

information can be used as a guideline

Cost estimates are also an important guide to the difficulty of an order. For instance, if the timing risk estimate is

significantly larger than the market impact forecast, one should apply a more aggressive trading strategy.

Conversely, a larger market impact may suggest adopting a more passive style

11

Post-Trade Analysis

Overview

The historical results of post trade analysis act as a measure of broker/trader performance. They may also inform

both investment and execution decisions

Clearly, there is a lot more to transaction costs than fees and commissions. Past performance is therefore an

important tool for comparing the quality of execution of both brokers and individual traders. Unbundling research

fees has also made it easier for investors to link costs to the execution, and so use post trade analysis to accurately

compare broker performance

Breaking down the costs into their components allows us to see where and how the costs (or slippage) occurred.

Detailed measurement helps to ensure that future efforts for cost reduction are focused on the correct stage of the

investment process. It may also be used to guide the execution method selection

Performance analysis is an important tool for post trade comparison of broker/trader/algorithm results. This is

mostly done via benchmark comparison or as a relative performance measurement

The post trade transactions costs can be determined via Perolds implementation shortfall. This measures the

difference between the idealized paper portfolio and the actually traded one

12

Post-Trade Analysis

Benchmarks

A good benchmark should be easy to track and readily verifiable, it should also provide an accurate performance

measurement. Johnson lists the following benchmarks for the example in the book

Post trade benchmarks, such as the closing price, are only known once the trading day is over. Intraday

benchmarks, such as VWAP, need constant updates as the trading day progresses. Other intraday measures such as

OHLC need the whole trading day to be completed to be known. Pre trade benchmarks, such as the previous close

or open, are known before the start of the trading day

13

Post-Trade Analysis

Relative Performance Measure

Kissell introduced the relative performance measure (RPM) as an alternative to price based benchmarks. It is based

on a comparison of what the trade achieved in relation to the rest of the market. In terms of volume, RPM

represents the ratio of the volume traded at a less favorable price to the total market volume:

=

=

Transaction cost is dependent on many factors: the assets characteristics (liquidity, volatility), market conditions

(price trends, momentum), trading strategy etc. Therefore, when comparing the performance of two separate

orders, we need to take these various factors into account and just comparing our executed price to one of the

price based benchmarks might not be enough

One of the main advantages of the RPM metric is that is that it is normalized, as the percentage rates the trade

relative to all other trades that occurred that day

14

Post-Trade Analysis

Post-Trade Transaction Costs

The total transaction costs of a trade may be determined by using Pernols implementation shortfall (IS) measure.

This is the difference in value between the idealized paper portfolio and the actually traded one. The theoretical

return depends on the price when the decision to invest was made (pd), the final market price (pN) and the size of

the investment (X). The real returns depend on the actual transaction costs. So, if xj represent the sizes of the

individual executions and pj are the achieved prices:

= (

Note this assumes that orders are fully executed. Hence, Kissell and Glantz extended it by an opportunity cost

factor as not every order will be fully executed.(X ) represents the unexecuted position

=

) =

) + (

)( ) +

For our example, we get an IS of 297bps + fixed costs, calculated as (133.5k / 4.5m)

Execution cost: (10k * 91.15 + 20k * 92.5 +15k* 93.8) (45k * 90) = 118,500

Order Value: 50k * 90 = 4.5m

15

Overview

There has been a considerable amount of research focused on breaking down trading costs. The table below

suggests one way of classifying the different constituents:

Differentiating between investment and trading related costs is useful since it helps identify who best can control

them. Investment related costs occur before the order is placed with the broker / execution trader, whereas

trading related costs account for all costs thereafter. Explicit costs can easily be measured, whereas implicit costs

are much harder to quantify

16

Investment Related Costs Taxes and Delay

Investment related costs can be a significant proportion of overall transaction costs. They primarily consist of delay

cost and taxes. The delay reflects the time from the investment decision being made (td) to when an order is

actually dispatched (t0)

Taxes must be incorporated in any investment strategy. They depend on asset class, legal form of the investor and

jurisdiction. For example, some countries levy capital gains taxes, whereas others do not. The same applies for

stamp duty on share purchases

The delay cost is caused by any price change from the initial decision to invest to when an order has actually been

received by a broker

17

Trading Related Costs - Overview

The explicit trading related costs comprise of commission and fees, which are usually known in advance and

open for negotiation

The most significant costs are the implicit trading related costs, primarily market impact and timing risk, but also

spread, price trend and opportunity cost

Spread cost is also an implicit cost since although being visible it is not always as easily measurable as commissions

or fees

Market impact represents a payment for liquidity (or immediacy) and a cost due to the information content of

the order.

The price trend represents the added burden caused by a trending market

Timing risk is primarily associated with the volatility of an assets price, as well as its liquidity

Opportunity costs represent the risk from not fully executing the order, possibly because the trading strategy

was too passive

18

Trading Related Costs Commissions, Fees and Spreads

Commissions are charged by brokers for agency trading to compensate them for their cost. They are generally

quoted in basis points or cents per contract. They have decreased significantly over time as most execution tasks

have been fully automatized so that less employees are needed

Fees represent the actual charges from trading. These may be from floor brokers, exchange fees as well as clearing

and settlement costs. Often brokers include them into their commission charge so that a client doesnt necessarily

know the exact breakdown between fees and commissions. Note that some exchanges and ECNs assigns costs only

to aggressively priced orders in order to encourage liquidity provision

Spread cost represents the difference between the best bid and ask prices at any given time. The spread

compensates those who provide liquidity. Clearly, aggressive trading styles will result in higher spread costs than

passive ones. Unsurprisingly, large cap and liquid stocks as well as liquid futures have lower spreads. More volatile

assets tend to have higher spreads

19

Trading Related Costs Market Impact and Price Trends

Market impact represents the price change caused by a specific trade or order. Generally, it has an adverse

effect, for instance helping drive prices up when are trying to buy. The exact market impact is the difference

between the actual price chart and the hypothetical one if our orders had not been created, hence it is difficult to

measure. Market impact can be broken down into temporary and permanent impact, where temporary reflects the

cost of demanding liquidity and permanent corresponds to the long term effect of our order, representing the

information content that it exposed to the market

Price trends describe the status when asset prices exhibit broadly consistent trends. This price drift, or

momentum, is also known as short-term alpha. An upward trend implies that prices will increase when buying and

vice versa. The price trend cost may be determined based on the difference between this trend price and the arrival

price. Reducing trend cost may be achieved by shortening the trading horizon and so increasing market impact

costs. So, for larger orders, one has to strike a balance between the two

20

Trading Related Costs Timing Risk and Opportunity Costs

Timing risk is used to represent the uncertainty of the transaction cost estimate. The two main sources of this

uncertainty are volatility in the assets price and traded volume. Price volatility is arguably the most important risk.

The more volatile an asset, the more likely its price will move away and so increase transaction costs. The liquidity

risk represents the uncertainty with respect to the market impact cost. Generally, market impact costs are

estimated based on historical volumes, so if the actual trading volumes differ significantly, this may result in a shift

in market impact

Opportunity cost reflects the cost of not fully executing an order. This may be because the assets price went

beyond the price limit or could just be due to insufficient liquidity. Either way, it represents a missed opportunity,

since the next day prices may move even further away. The overall cost may be determined as the product of the

remaining order size and the price difference between the final price and the arrival price:

(

)( 0 )

Unlike the other cost components, opportunity cost represents a virtual loss rather than a physical one and is only

realized if a new order makes up the remainder at a less favorable price

21

Transaction costs can have a significant impact on investment returns. Therefore, it is important to both measure

and analyse them if best execution is to be achieved

Implementation shortfall or slippage is the difference in performance between an actual portfolio and its

theoretical paper equivalent

Pre trade analysis concentrates on estimating the expected difficulty of trading and potential transaction costs

Transaction costs can be decomposed into a wide range of different components. Among them are broker costs,

spread costs, delay costs, market impact, timing risk and opportunity costs

Transaction costs are closely related to market liquidity and volatility. They become cheaper with higher liquidity

and lower volatility

Questions?

22

Sources

Optimal Execution of Portfolio Transactions by Robert Almgren and Neill Chriss, published in Journal of Risk,

2000, vol. 3, p. 5 - 29

23

Algorithmic Trading

Session 10

Performance Analysis I

Performance Measurement

Oliver Steinki, CFA, FRM

Outline

Introduction

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

Performance Analysis is conducted after the trade has been closed and used in a

backtesting context to judge whether the strategy is successful or not. In general, we can

judge the performance according to five different metrics: return, risk, efficiency, trade

frequency and leverage

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Session 11 & 12: Performance Analysis

PERFORMANCE

ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

Introduction

Performance Measurement

Proper performance measurement should involve a recognition of both the return and the riskiness of the

investment

When two investments returns are compared, their relative risk must also be considered

A positive function of expected return

A negative function of the return variance

Introduction

A Historical Guideline

The 1968 Bank Administration Institutes Measuring the Investment Performance of Pension Funds concluded:

Performance of a fund should be measured by computing the actual rates of return on a funds assets

These rates of return should be based on the market value of the funds assets

Complete evaluation of the managers performance must include examining a measure of the degree of risk

taken in the fund

Circumstances under which fund managers must operate vary so greatly that indiscriminate comparisons

among funds might reflect differences in these circumstances rather than in the ability of managers

Arithmetic vs. Geometric Mean

The arithmetic mean is not a useful statistic in evaluating growth. It might give misleading information as a 50

percent decline in one period followed by a 50 percent increase in the next period does not produce an average

return of zero

Consider the following example from the assigned reading. 44 Wall Street and Mutual Shares both had good

returns over the 1975 to 1988 period:

Review: Why the Arithmetic Mean Is Misleading

The proper measure of average investment return over time is the geometric mean:

1/ n

GM Ri 1

i 1

where Ri the return relative in period i

44 Wall Street: 7.9 percent

Mutual Shares: 22.7 percent

The geometric mean correctly identifies Mutual Shares as the better investment over the 1975 to 1988 period

Dollars Are More Important Than Percentages

Measuring dollar values clearly shows that Mutual shares significantly outperformed 44 Wall Street:

$200,000.00

$180,000.00

$160,000.00

$140,000.00

$120,000.00

$100,000.00

$80,000.00

$60,000.00

$40,000.00

$20,000.00

$Year

44 Wall Street

Mutual Shares

Dollars Are More Important Than Percentages

Fund A has $40 million in investments and earned 12 percent last period

The correct way to determine the return of both funds combined is to weigh the funds returns by the dollar

amounts:

$40, 000, 000

$250, 000

In fact, 99.38 percent of the $40.25 million managed by this person earned 12 percent. Only 0.62 percent

earned the higher rate

Sharpe and Treynor Measures

Sharpe measure

Treynor measure

R Rf

R Rf

R f risk-free rate

beta

The Sharpe measure evaluates return relative to total risk. Hence, it is appropriate for a well-diversified

portfolio, but not for individual securities

The Treynor measure evaluates the return relative to beta, a measure of systematic risk. Hence, it ignores any

unsystematic risk and is therefore also not appropriate for individual securities

10

Jensen Measure

Rit R ft i Rmt R ft

The constant term should be zero. Securities with a beta of zero should have an excess return of zero according to

classical finance theory

According to the Jensen measure, if a portfolio manager is better-than-average, the alpha of the portfolio will be

positive

However, the use of Treynor and Jensen Measure relies on measuring the market return and CAPM

Evidence continues to accumulate that may ultimately displace the CAPM, but Arbitrage pricing model,

multi-factor CAPMs, inflation-adjusted CAPM could help

11

Famas Return Decomposition

Famas return decomposition can be used to assess why an investment performed better or worse than expected:

Diversification is the difference between the return corresponding to the beta implied by the total risk of the

portfolio and the return corresponding to its actual beta

Net selectivity measures the portion of the return from

selectivity in excess of that provided by the

diversification component

12

Overview

The dollar-weighted rate of return is analogous to the internal rate of return in corporate finance. It is the

rate of return that makes the present value of a series of cash flows equal to the cost of the investment

cost

C3

C1

C2

(1 R) (1 R) 2 (1 R)3

The time-weighted rate of return measures the compound growth rate of an investment. It eliminates the

effect of cash inflows and outflows by computing a return for each period and linking them (like the geometric

mean return):

The time-weighted rate of return and the dollar-weighted rate of return will be equal if there are no inflows or

outflows from the portfolio

13

Overview

The owner of a fund often takes periodic distributions from the portfolio, and may occasionally add to it

The established way to calculate portfolio performance in this situation is via a time-weighted rate of return:

Modified Bank Administration Institute (BAI) method

Is cumbersome because it requires determining a value for the portfolio each time any cash flow occurs. This

might be interest, dividends, or additions to or withdrawals

Approximates the internal rate of return for the investment over the period in question

Can be complicated with a large portfolio that might conceivably have a cash flow every day

14

Daily Valuation Method

n

Rdaily Si 1

i 1

MVEi

where S

MVBi

MVEi = market value of the portfolio at the end of period i before any cash flows in period i but including accrued

income for the period

MVBi = market value of the portfolio at the beginning of period i including any cash flows at the end of the previous

subperiod and including accrued income

15

BAI method

n

MVE Fi (1 R) wi

i 1

MVE market value at the end of the period,

including accrued income

F0 market value at the start of the period

CD Di

CD

CD total number of days in the period

Di number of days since the beginning of the period

wi

16

Example

An investor has an account with a mutual fund and dollar cost averages by putting $100 per month into the fund

The following table shows the activity and results over a seven-month period

Date

Description

$ Amount

Price

January 1

balance

forward

January 3

purchase

100

$7.00

February 1

purchase

100

March 1

purchase

March 23

liquidation

April 3

Shares

$7.00

Total Shares

Value

1,080.011

$7,560.08

14.286

1,094.297

$7,660.08

$7.91

12.642

1,106.939

$8,755.89

100

$7.84

12.755

1,119.694

$8,778.40

5,000

$8.13

-615.006

504.688

$4,103.11

purchase

100

$8.34

11.900

516.678

$4,309.09

May 1

purchase

100

$9.00

11.111

527.789

$4,750.10

June 1

purchase

100

$9.74

10.267

538.056

$5,240.67

July 3

purchase

100

$9.24

10.823

548.879

$5,071.64

August 1

purchase

100

$9.84

10.163

559.042

$5,500.97

17

Example: Daily Valuation Method

The daily valuation method returns a time-weighted return of 40.6 percent over the seven-month period

Date

Sub Period

MVB

Cash Flow

January 1

Ending

Value

MVE

MVE/MVB

$7,560.08

January 3

$7,560.08

100

$7,660.08

$7,560.08

1.00

February 1

$7,660.08

100

$8,755.89

$8,655.89

1.13

March 1

$8,755.89

100

$8,778.40

$8,678.40

0.991

March 23

$8,778.40

5,000

$4,103.11

$9,103.11

1.037

April 3

$4,103.11

100

$4,309.09

$4,209.09

1.026

May 1

$4,309.09

100

$4,750.10

$4,650.10

1.079

June 1

$4,750.10

100

$5,240.67

$5,140.67

1.082

July 3

$5,240.67

100

$5,071.64

$4,971.64

0.949

August 1

$5,071.64

100

$5,500.97

$5,400.97

1.065

18

Example: BAI Method

The BAI method returns a time-weighted return of 42.1 percent over the seven-month period. However, it

requires a function like solver in Excel

Date

Weight

(214-days)/214

Day

Cash Flow

January 1

1.000

January 3

0.9907

$7,560.06

$10,741.36

February 1

31

0.8551

$100

$141.62

March 1

60

0.7196

$100

$135.03

March 23

83

0.6121

$5,000

$128.75

April 3

94

0.5607

$100

($6,199.20)

May 1

123

0.4252

$100

$121.77

June 1

153

0.2850

$100

$116.17

July 3

185

0.1355

$100

$104.87

August 1

214

0.0000

$100

$100

Total

$5,500.84

19

Performance evaluation is a critical part of the portfolio management process. The central issue is coupling a

measure of risk with the return of a portfolio.The measurement of risk is often neglected

Average returns over time should be measured using a geometric growth rate. The arithmetic mean gives

misleading results and should not be used to compare competing investment funds or strategies

The Sharpe and Treynor measures are the two leading classical performance indicators. Their calculations are

similar, except that the Sharpe measure uses the standard deviation of returns as a risk measure whereas the Treynor

measure uses beta. Jensens measure is not that common anymore, although his definition of alpha is still used for

outperformance

When a portfolio has frequent cash deposits and withdrawals, it is best to calculate performance via a timeweighted rate of return

Questions?

20

Sources

21

Algorithmic Trading

Session 11

Performance Analysis II

Risk, Return and Efficiency Ratios

Oliver Steinki, CFA, FRM

Outline

Introduction

Returns

Risk

Efficiency

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

Performance Analysis is conducted after the trade has been closed and used in a

backtesting context to judge whether the strategy is successful or not. In general, we can

judge the performance according to five different metrics: return, risk, efficiency, trade

frequency and leverage

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Todays Session 11: Performance Analysis I: Returns, risk and efficiency

Session 12: Performance Analysis II: Frequency of trades and leverage

PERFORMANCE

ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

Introduction

Performance Analysis

Performance Analysis is a critical aspect of portfolio management. We split the analysis into five metrics: return,

risk, efficiency, trade frequency and leverage

Risk is defined as the downside deviation of returns and can be expressed in terms such as standard deviation,

downside standard deviation, maximum drawdown and length of maximum drawdown

Efficiency measures set risk and return in relation. They are expressed through classical ratios such as Sharpe and

Treynor measure, but also more modern ones such as the Sortino ratio. Win/Loss and Average Profit/Loss also

indicate efficiency. A comparison to a benchmark is an indirect way of efficiency measurement as one targets a

better return than the benchmark with similar risk or similar returns with lower risk

Trade frequency is important to judge the impact of transaction costs and infrastructure requirements. The higher

the trade frequency, the bigger the impact of transactions costs and requirement of a sophisticated infrastructure

Leverage is another expression for money management. It deals with the question of which percentage of the total

portfolio to invest in a given trade and how one can optimize this

Introduction

Methodology

The methodology of a trading strategy is of qualitative nature, yet important for investors. Many investors have a

bias towards a certain strategy, e.g. momentum based, mean-reverting, market-neutral or directional

The level of complexity of the methodology is an important criteria of quantitative trading strategies. Although it

does not have a direct impact on the quantitative performance metrics we cover, it will be relevant for your choice

of potential investors as they might consider your strategy a black box if it is too complex for them

Does the methodology rely on sophisticated or complex statistical or machine learning techniques that are hard to

understand and require a PhD in statistics to grasp? Do these techniques introduce a significant quantity of

parameters, which might lead to optimisation bias? Is the strategy likely to withstand a regime change (i.e. potential

new regulation of financial markets)? All these factors will also determine who your potential investors are

Returns

Recap

We have seen in previous sessions that the arithmetic mean is not a useful statistic in evaluating growth. It might

give misleading information as a 50 percent decline in one period followed by a 50 percent increase in the next

period does not produce an average return of zero

The proper measure of average investment return over time is the geometric mean. It is this growth rate that any

rational investor tries to maximize

Investors are not only interested in the total return, but also in the average annualized returns and the best and

worst days / months / years

Risk

Recap

Volatility is used as a proxy for risk of a strategy. Most often, the standard deviation of returns is used as volatility

measure, although more advanced techniques only consider the downside deviation of returns. A higher frequency

strategy will require greater sampling rates of standard deviation, but a shorter overall time period of

measurement

The maximum drawdown is the largest overall peak-to-trough percentage drop on the equity curve of the

strategy. Momentum strategies are well known to suffer from periods of extended drawdowns (due to a string of

many incremental losing trades). Many traders will give up in periods of extended drawdown, even if historical

testing has suggested this is "business as usual" for the strategy. You will need to determine what percentage of

drawdown (and over what time period) you can accept before you cease trading your strategy, especially if you

trade your own money. This is a highly personal decision and thus must be considered carefully. Investors will also

give you some form of maximum drawdown constraint and might pull their money if you break these

The length of the peak to valley measures how quickly the equity curve falls from the peak to the subsequent

bottom. The peak to through or recovery measures the time it takes one reaches again the same height of the

equity curve as the previous peak

Efficiency Measures

Recap

When two investments returns are compared, their relative risk must also be considered. Efficiency measures set

returns in relation to risk in order to get some form of x units of return per z units of risk measure

Examples are classical ratios such as Sharpe and Treynor measure. Modern ratios focus on a more advanced

definition of risk, such as the Sortino ratio

Win/Loss and Average Profit/Loss also indicate efficiency. Ideally one combines a high percentage of winning

trades with higher average profits than average losses

A comparison to a benchmark is an indirect way of efficiency measurement as one targets a better return than the

benchmark with similar risk or similar returns with lower risk

Efficiency Measures

Review: Performance Drivers of Quantitative Trading Strategies

Quantitative Investment Strategies are driven by four success factors: trade frequency, success ratio, return

distributions when right/wrong and leverage ratio

The higher the success ratio, the more likely it is to achieve a positive return over a one year period. Higher

volatility of the underlying assuming constant success ratio will lead to higher expected returns

The distribution of returns when being right / wrong is especially important for strategies with heavy long or short

bias. Strategies with balanced long/short positions and hence similar distributions when right/wrong are less

impacted by these distributional patterns. Downside risk can further be limited through active risk/money

management, e.g. stop loss orders

Leverage plays an important role to scale returns and can be seen as an artificial way to increase the volatility of

the traded underlying. It is at the core of the money management question to determine the ideal betting size. For

example, a 10 times leveraged position on an asset with 1% daily moves is similar to a full non-leveraged position

on an asset with 10% daily moves

Performance Analysis is a critical aspect of portfolio management. We split the analysis into five metrics: return,

risk, efficiency, trade frequency and leverage

Risk is defined as the downside deviation of returns and can be expressed in terms such as standard deviation,

downside standard deviation, maximum drawdown and length of maximum drawdown

Efficiency measures set risk and return in relation. They are expressed through classical ratios such as Sharpe and

Treynor measure, but also more modern ones such as the Sortino ratio. Win/Loss and Average Profit/Loss also

indicate efficiency. A comparison to a benchmark is an indirect way of efficiency measurement as one targets a

better return than the benchmark with similar risk or similar returns with lower risk

Questions?

10

Sources

11

Algorithmic Trading

Session 12

Performance Analysis III

Trade Frequency and Optimal Leverage

Oliver Steinki, CFA, FRM

Outline

Introduction

Trade Frequency

Optimal Leverage

Sources

Introduction

Where Do We Stand in the Algo Prop Trading Framework?

SIGNAL GENERATION

three subsequent steps: Signal Generation, Trade Implementation and Performance

Analysis

backtesting context to judge whether the strategy is successful or not. In general, we can

judge the performance according to five different metrics: return, risk, efficiency, trade

frequency and leverage

HOW TO TRADE

TRADE

IMPLEMENTATION

SIZE AND EXECUTE

ORDERS, INCL. EXIT

Session 11: Performance Analysis I: Returns, risk and efficiency

Todays Session 12: Performance Analysis II: Frequency of trades and leverage

PERFORMANCE

ANALYSIS

RETURN, RISK AND

EFFICIENCY RATIOS

Introduction

Performance Analysis

Performance Analysis is a critical aspect of portfolio management. We split the analysis into five metrics: return,

risk, efficiency, trade frequency and leverage

Risk is defined as the downside deviation of returns and can be expressed in terms such as standard deviation,

downside standard deviation, maximum drawdown and length of maximum drawdown

Efficiency measures set risk and return in relation. They are expressed through classical ratios such as Sharpe and

Treynor measure, but also more modern ones such as the Sortino ratio. Win/Loss and Average Profit/Loss also

indicate efficiency. A comparison to a benchmark is an indirect way of efficiency measurement as one targets a

better return than the benchmark with similar risk or similar returns with lower risk

Trade frequency is important to judge the impact of transaction costs and infrastructure requirements. The higher

the trade frequency, the bigger the impact of transactions costs and requirement of a sophisticated infrastructure

Leverage is another expression for money management. It deals with the question of which percentage of the total

portfolio to invest in a given trade and how one can optimize this

Introduction

Review: Performance Drivers of Quantitative Trading Strategies

distributions when right/wrong and leverage ratio

The higher the success ratio, the more likely it is to achieve a positive return over a one year period. Higher

volatility of the underlying assuming constant success ratio will lead to higher expected returns

The distribution of returns when being right / wrong is especially important for strategies with heavy long or short

bias. Strategies with balanced long/short positions and hence similar distributions when right/wrong are less

impacted by these distributional patterns. Downside risk can further be limited through active risk/money

management, e.g. stop loss orders

Leverage plays an important role to scale returns and can be seen as an artificial way to increase the volatility of

the traded underlying. It is at the core of the money management question to determine the ideal betting size. For

example, a 10 times leveraged position on an asset with 1% daily moves is similar to a full non-leveraged position

on an asset with 10% daily moves

Trade Frequency

Classification

Time Frames:

Long Term: Months to Years

Intraday: Seconds to Hours

The more frequent the trading, the higher the transaction costs

Physical Infrastructure

The more frequent the trading, the higher the requirement to have a sophisticated trading infrastructure

Trade Frequency

Infrastructure Requirements

Data feeds: Although end of day data is available at low costs, tick by tick data can cost substantial amounts of

money

Data Storage: The more data you receive and the more frequent, the higher your data storage requirements. For

every underlying you store, you should at least store OHLC for every day and Volume data. Next to this, you

should also save information such as tickers, expiry dates, multiples, exchange on which the instrument is traded,

time zone of the exchange, trading hours, currency and security type

Data Processing: The more complex your trade signal generation process, the more computational power you

will need. Additionally, the more time critical your investment strategy, you need to invest in computational

power to minimize the time period between receiving the last information you need for your trade signal

generation and trade implementation.

Backup Systems: When you start out, a simple backup in the cloud or on an external hard disk will do. As more

you grow and attract institutional clients, they will be very keen about your business contingency processes.

Ideally you run the same system in parallel in two to three locations so that there is no impact on trading if one

system fails

Optimal Leverage

Risk Management

Well discuss several methods of computing the optimal leverage that maximizes the compounded growth rate.

Each method has its own assumptions and drawbacks. But, in all cases, we have to make the assumption that the

future probability distribution of returns of the market is the same as in the past. This is usually an incorrect

assumption, but this is the best that quantitative models can do. Even more restrictive, many risk management

techniques assume further that the probability distribution of returns of the strategy itself is the same as in the past.

And finally, the most restrictive of all assumes that the probability distribution of returns of the strategy is

Gaussian

As an institutional asset manager, client constraints limit the maximum drawdown of an account. In this case, the

maximum drawdown allowed forms an additional constraint in the leverage optimization problem

Also, it may be wise to avoid trading altogether during times when the risk of loss is high, hence setting leverage

to close to 0. Therefore, many algorithmic trading strategies reduce exposure during times of increased expected

volatility such as central bank announcements or significant macroeconomic numbers

No matter how the optimal leverage is determined, the one central theme is that the leverage should be kept

constant. This is necessary to optimize the growth rate whether or not we have the maximum drawdown

constraint. Keeping a constant leverage may sound rather mundane, but can be counterintuitive when put into

action

Optimal Leverage

Kelly Formula

If one assumes that the probability distribution of returns is Gaussian, the Kelly formula gives us a very simple

answer for optimal leverage f: f = m / s2 where m is the mean excess return and s2 is the variance of the excess

returns

It can be proven that if the Gaussian assumption is a good approximation, then the Kelly leverage f will generate

the highest compounded growth rate of equity, assuming that all profits are reinvested (see optional reading)

However, even if the Gaussian assumption is really valid, we will inevitably suffer estimation errors when we try to

estimate what the true mean and variance of the excess return are. And no matter how good ones estimation

method is, there is no guarantee that the future mean and variance will be the same as the historical ones. The

consequence of using an overestimated mean or an underestimated variance is dire: Either case will lead to an

overestimated optimal leverage, and if this overestimated leverage is high enough, it will eventually lead to ruin:

equity going to zero

On the other hand, the consequence of using an underestimated leverage is merely a submaximal compounded

growth rate. Many traders justifiably prefer the later scenario, and they routinely deploy a leverage equal to half of

what the Kelly formula recommends: the so-called half-Kelly leverage

Optimal Leverage

Simulated Returns

If one relaxes the Gaussian assumption and substitutes another analytic form (e.g., Students t) for the returns

distribution to take into account the fat tails, we can still follow the derivations of the Kelly formula in Thorps

paper and arrive at another optimal leverage, though the formula wont be as simple anymore (This is true as long

as the distribution has a finite number of moments, unlike, for example, the Pareto Levy distribution). For some

distributions, it may not even be possible to arrive at an analytic answer. This is where Monte Carlo simulations can

help

The expected value of the compounded growth rate as a function of the leverage f is (assuming for simplicity that

the risk-free rate is zero): g( f ) = log(1 + fR), where indicates an average over some random sampling of

the unlevered return-per-bar R(t) of the strategy (not of the market prices) based on some probability distribution

of R

Even though we do not know the true distribution of R, we can use the so-called Pearson system to model it.

model it. The Pearson system takes as input the mean, standard deviation, skewness, and kurtosis of the empirical

distribution of R, and models it as one of seven probability distributions expressible analytically encompassing

Gaussian, beta, gamma, Students t, and so on. Of course, these are not the most general distributions possible. The

empirical distribution might have nonzero higher moments that are not captured by the Pearson system and might,

in fact, have infi nite higher moments, as in the case of the Pareto Levy distribution. But to capture all the higher

moments invites data-snooping bias due to the limited amount of empirical data usually available. So, for all

practical purposes, we use the Pearson system for our Monte Carlo sampling

10

Optimal Leverage

Optimizing Historical Growth Rate

Instead of optimizing the expected value of the growth rate using our analytical probability distribution of returns

one can of course just optimize the historical growth rate in the backtest with respect to the leverage. We just need

one particular realized set of returns: that which actually occurred in the backtest

This method suffers the usual drawback of parameter optimization in backtest: data-snooping bias. In general, the

optimal leverage for this particular historical realization of the strategy returns wont be optimal for a different

realization that will occur in the future. Unlike Monte Carlo optimization, the historical returns offer insufficient

data to determine an optimal leverage that works well for many realizations

Despite these caveats, brute force optimization over the backtest returns sometimes does give a very similar

answer to both the Kelly leverage and Monte Carlo optimization

11

Optimal Leverage

Maximum Drawdown

Most portfolio managers manage (at least in part) other peoples assets, therefore maximizing the long-term

growth rate is not the only objective. Often, their clients (or employers) will insist that the absolute value of the

drawdown (return calculated from the historic high watermark) should never exceed a certain maximum. That is

to say, they dictate what the maximum drawdown can be. This requirement translates into an additional constraint

into our leverage optimization problem

Unfortunately, this translation is not as simple as multiplying the unconstrained optimal leverage by the ratio of the

maximum drawdown allowed and the original unconstrained maximum drawdown. Therefore, if the ideal leverage

of say 40% results in a maximum drawdown of 50% and your drawdown constraint is 25%, you can not just

reduce the leverage to 20%. The factor depends on the exact series of simulated returns, and so are not exactly

reproducible

In order to prevent future drawdowns from breaking the constraint, we can either use constant proportion

insurance or impose a stop loss

12

Optimal Leverage

CPPI

The often conflicting goals of wishing to maximize compounded growth rate while limiting the maximum

drawdown have been discussed already. There is one method that allows us to fulfill both wishes: constant

proportion portfolio insurance (CPPI)

Suppose the optimal Kelly leverage of our strategy is determined to be f. And suppose we are allowed a maximum

drawdown of D. We can simply set aside D of our initial total account equity for trading, and apply a leverage of

f to this subaccount to determine our portfolio market value. The other 1 D of the account will be sitting in

cash. We can then be assured that we wont lose all of the equity of this subaccount, or, equivalently, we wont

suffer a drawdown of more than D in our total account

If the trading strategy is profitable and the total account equity reaches a new high water mark, then we can reset

our subaccount equity so that it is again D of the total equity, moving some cash back to the cash account.

However, if the strategy suffers losses, we will not transfer any cash between the cash and the trading subaccount.

Of course, if the losses continue and we lose all the equity in the trading subaccount, we have to abandon the

strategy because it has reached our maximum allowed drawdown of D. Therefore, in addition to limiting our

drawdown, this scheme serves as a graceful, principled way to wind down a losing strategy

13

Optimal Leverage

Stop Loss

There are two ways to use stop losses. The common usage is to use stop loss to exit an existing position whenever

its unrealized P&L drops below a threshold. But after we exit this position, we are free to reenter into a new

position, perhaps even one of the same sign, sometime later. In other words, we are not concerned about the

cumulative P&L or the drawdown of the strategy

The less common usage is to use stop loss to exit the strategy completely when our drawdown drops below a

threshold. This usage of stop loss is awkward - it can happen only once during the lifetime of a strategy, and

ideally we would never have to use it. That is the reason why CPPI is preferred over using stop loss for the same

protection.

Stop loss can only prevent the unrealized P&L from exceeding our selfimposed limit if the market is always open

whenever we are holding a position. For example, it is effective if we do not hold positions after the market closes

or if we are trading in currencies or some futures where the electronic market is open 24/5. Otherwise, if the

prices gap down or up when the market reopens, the stop loss may be executed at a price much worse than what

our maximum allowable loss dictates

In some extreme circumstances, stop loss is useless even if the market is open but when all liquidity providers

decide to withdraw their liquidity simultaneously as happened during the flash crash in May 2010.

14

risk, efficiency, trade frequency and leverage

Trade frequency is important to judge the impact of transaction costs and infrastructure requirements. The higher

the trade frequency, the bigger the impact of transactions costs and requirement of a sophisticated infrastructure

Leverage is another expression for money management. It deals with the question of which percentage of the total

portfolio to invest in a given trade and how one can optimize this

Questions?

15

Sources

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