Picking Upward Nickels Inwards Front End Of Steamrollers

When I was growing upward inwards the trading world, high Sharpe ratio was the holy grail. People kept forgetting the possibility of "black swan" events, alone late popularized yesteryear Nassim Taleb, which tin post away wipe out years of steady gains inwards i disastrous stroke. (For a fascinating interview of Taleb yesteryear the famous Malcolm Gladwell, run across this onetime New Yorker article. It includes a contrast alongside Victor Niederhoffer's trading style, summation a rare close-up sentiment of the painful daily operations of Taleb's hedge fund.)

Now, however, the pendulum seems to accept swung a niggling every bit good far inwards the other direction. Whenever I refer a high Sharpe-ratio strategy to but about experienced investor, I am oftentimes confronted alongside nighttime musings of "picking upward nickels inwards front end of steamrollers", every bit if all high Sharpe-ratio strategies consist of shorting out-of-the-money telephone yell upward options.

But many high Sharpe-ratio strategies are not akin to shorting out-of-the-money calls. My favorite lawsuit is that of short-term mean-reverting strategies. These strategies non alone render consistent modest gains nether normal marketplace conditions, but inwards contrast to shorting calls, they brand out-size gains especially when disasters struck. Indeed, they hand us the best of both worlds. (Proof? Just backtest whatever short-term mean-reverting strategies over 2008 data.) How tin post away that be?

There are multiple reasons why short-term mean-reverting strategies accept such delightful properties:

1. Typically, nosotros piece of employment into into positions alone after the disaster has struck, non before.
   
2. If you lot believe a certainly marketplace is mean-reverting, together with your strategy purchase depression together with sell high, together with then of degree you lot volition brand much to a greater extent than coin when the marketplace is abnormally depressed.
3. Even inwards the rare occasion when the marketplace does non mean-revert afterward a disaster, the marketplace is unlikely to become downward much farther during the curt fourth dimension menses when nosotros are belongings the position.

"Short-term" is indeed the telephone commutation to the success of these strategies. In contrast to the LTCM debacle, where they would boot the bucket on piling on to a losing position solar daytime afterward solar daytime hoping it would mean-revert but about day, short-term traders liquidate their positions at the halt of a fixed fourth dimension period, whether they win or lose. This greatly limits the possibility of ruin together with leaves our equity intact to attain out but about other solar daytime inwards the statistical game.

So, telephone yell upward me old-fashioned, but I soundless dear high Sharpe-ratio strategies.

Are Fiscal Speculations Actually Harmful Human Activities?

It is worrisome when non i but ii eminent economists denounced fiscal speculation equally "harmful human activities" inwards the brusk infinite of 2 weeks. (See Paul Krugman's column here in addition to Robert Frank's here.) It is to a greater extent than worrisome when their proposed cure to this evil is to apply a fiscal transaction taxation to all fiscal transactions.

Granted, yous tin ever uncovering this or that province of affairs when fiscal speculation did crusade harm. Maybe speculation did crusade the housing bubble. Maybe speculation did crusade an pose out energy toll bubble. In the same vein, yous tin also struggle that driving is a harmful human activity because cars did crusade a few horrific traffic accidents.

No, nosotros can't focus on a few catastrophes if nosotros were to struggle that fiscal speculation is harmful. We convey to focus on whether it is harmful on average. And on this point, I haven't seen our eminent economists introduce whatever scientific evidence. On the other hand, equally an ex-physicist in addition to an Einstein-devotee, I tin imagine some  idea experiments (or gedankenexperiment as Einstein would telephone weep upwardly them), where I tin illustrate how the absence of fiscal speculation tin clearly last detrimental to the interests of the much-beloved long-term investors. To brand a point, a gedankenexperiment is unremarkably constructed then that the weather condition are extreme in addition to unrealistic. So hither I volition assume that the fiscal transaction taxation is then onerous that no hedge funds in addition to other short-term traders be anymore.

Gedankenexperiment A: Ms. Smith only received a bonus from her project in addition to would similar to purchase i of her favorite stocks inwards her retirement account. Unfortunately, on the 24-hour interval she placed her order, a major usual fund was rebalancing its portfolio in addition to had also decided to shift assets into that stock. In the absence of hedge funds in addition to other speculators selling or fifty-fifty shorting this stock, the toll of that stock went upwardly 40% from the 24-hour interval before. Not knowing that the crusade of this spike was a temporary liquidity squeeze, in addition to afraid that she would convey to pay fifty-fifty to a greater extent than inwards the future, Ms. Smith paid the inquire toll in addition to bought the stock that day. Influenza A virus subtype H5N1 calendar week later, the stock toll roughshod 45% from the acme after the usual fund buying subsided. Ms. Smith was mortified.

Gedankenexperiment B: Mr. Smith decided that the stock marketplace is much likewise volatile (due to the lack of speculators!) in addition to opted to invest his savings into usual funds instead. He took a hold back at his favorite usual fund's performance, in addition to unfortunately, its recent functioning seemed to last quite a few notches below its historical average. The fund managing director explained on her website that since her fund derived its superior functioning from chop-chop liquidating holdings inwards companies that announced hapless earnings, the absence of liquidity inwards the stock marketplace oftentimes forced her to sell into an abyss. Disgusted, Mr. Smith opted to proceed his savings inwards his savings account.

Of course, our economists volition tell that the taxation is non then onerous that it volition deprive the marketplace of all speculators (only the bad ones!?). But has anyone studied if nosotros impose 1 unit of measurement of tax, how many units of liquidity inwards the marketplace volition last drained, in addition to inwards turn, how many additional units of transaction costs (which include implicit costs due to the increased volatility of securities) would last borne past times an average investor, who may non convey the luxury of submitting a boundary fellowship in addition to waiting for the fellowship to last filled?

Selecting Tradeable Pairs: Which Mensurate To Use?

A invitee weblog past times Paul Farrington

One of the close of import factors inward statistical arbitrage pairs trading is the choice of the paired instruments.  We tin role basic heuristics to direct us, such equally grouping stocks past times manufacture inward the anticipation that stocks alongside like key characteristics volition part element run a peril together with tend to present co-movement.  But this even thus leaves us alongside potentially thousands of combinations.  There are to a greater extent than or less statistical techniques nosotros tin role to quantify the tradeability of a pair: 1 approach is to calculate the correlation coefficient of each pair's provide series. Another is to regard cointegration measures on the ratio of the prices, to run across if it remains stationary over time.

In this article I briefly summarise the option approaches together with employ them to a universe of stock pairs inward the petroleum together with gas industry.  To stair out how effective each stair out is inward existent globe trading, I dorsum exam the pairs using a uncomplicated agency reversion system, thus regress the generated win charge per unit of measurement against the statistical results.  Some basic insights emerge equally to the effectiveness of correlation together with cointegration equally tools for selecting candidate pairs.

Please view http://www.paulfarrington.com/research/Selecting%20tradeable%20pairs.htm for details of my methodology together with results.

Does Averaging-In Work?

Ron Schoenberg as well as Al Corwin of late did around interesting research on the trading technique of "averaging-in". For e.g.:  Let's enjoin you lot bring $4 to invest. If a future's cost of late drops to $2, though you lot await it to eventually revert to $3. Should you

A) purchase 1 contract at $2, as well as hold back for the cost to possibly drop to $1 as well as so purchase ii to a greater extent than contracts (i.e. averaging-in); or
B) purchase ii contracts at $2 each;  or
C) hold back to possibly buy four contracts at $1 each?

Let's assume that the probability of the cost dropping to $1 1 time you lot bring reached $2 is p. It is tardily to run into that the average profits of the three options are the following:
A) p*(1*$1+2*$2) + (1-p)*(1*$1)=1+4p;
B) 2; and
C) p4*$2=8p.

Profit Influenza A virus subtype H5N1 is lower than C when p > 1/4, as well as profits Influenza A virus subtype H5N1 is lower than profits C when p > 1/4. Hence, whatsoever p is,  either selection B or C is to a greater extent than profitable than averaging in, as well as thence averaging-in tin never last optimal.

From a backtest indicate of view, the Schoenberg-Corwin declaration is impeccable, since nosotros know what p is for the historical period. You mightiness argue, however, that fiscal markets is non quite stationary, as well as inwards my example, if the historical value of p was less than 1/4, it is quite possible that the hereafter value tin last to a greater extent than than 1/4. This is why I never brand likewise much endeavour to optimize parameters inwards general, as well as I tin sympathise alongside traders who insist on averaging-in fifty-fifty inwards the confront of this company slice of research!

Excel Adf Test

Some readers bring asked whether in that place is an Excel version of the ADF exam for cointegration (mentioned inwards articles here or here.) You tin forcefulness out download i such package here (Hat tip: Bruce H.).

And every bit always, you lot tin forcefulness out download the Matlab version from spatial-econometrics.com.

A Method For Optimizing Parameters

Most trading systems own got a issue of parameters embedded, parameters such equally the lookback period, the entry in addition to perish thresholds, in addition to then on. Readers of my weblog (for e.g., here in addition to here) in addition to my book would know my persuasion on parameter optimization: I am no big fan of it. This is because I believe fiscal fourth dimension serial is likewise non-stationary to permit i to enjoin what was optimal inwards the backtest is necessarily optimal inwards the future. Most traders I know would rather merchandise a strategy that is insensitive to modest changes inwards parameters, or alternatively, a "parameterless" strategy that is effectively an average of models amongst dissimilar parameters.

That existence said, if you lot tin solely merchandise i model amongst i specific fix of parameters, it is rational to inquire how i tin choice the best (optimal) fix of parameters. Many trading models own got a adept issue of parameters, in addition to it is quite onerous to detect the optimal values of all these parameters simultaneously. Recently, Ron Schoenberg published an article inwards the Futures Magazine that details a agency to achieve this amongst simply a tiny sum of figurer power.

The fundamental technique that Ron uses is cubic polynomial tally of the P&L surface equally a constituent of the parameters. Ron uses the VIX RSI strategy inwards Larry Connors' majority "Short Term Trading Strategies That Work" equally an example. This strategy has five parameters to hold upwards optimized, but Ron solely needs to compute the P&L for 62 dissimilar sets of parameters, in addition to the whole physical care for solely takes 58 seconds.

Although Ron has confirmed that nigh of the parameters that Connors picked are about optimal, he did detect a few surprises: namely, that RSI of menses three or iv is significantly to a greater extent than profitable than the ii that Connors used, at to the lowest degree inwards the backtest period.

Now, for a truthful essay out of this optimization, it would hold upwards helpful if Ron performed this optimization withholding some out-of-sample data, in addition to run into if these parameters are notwithstanding optimal inwards that withheld information set. Since he didn't produce that, nosotros demand to hold off for some other yr to detect out ourselves!

Pairs Trading Workshop Inward Hong Kong

For my readers inward Asia, I volition endure conducting a pairs trading workshop inward Hong Kong on March 10-11. This workshop is organized yesteryear the Technical Analyst periodical in addition to is like to the i I gave inward London final year.
However, I accept added a few useful insights based on audience feedback. As always, no prior noesis of Matlab or advanced statistics is assumed. The numerous in-class exercises should endure sufficient to convey your Matlab programming skills upward to speed.

Conference On The Sociology Of Quantitative Finance

A novel conference called Psi-Q volition last held inward London this June, featuring luminaries inward the academic quantitative finance world, also every bit conduct a opportunity as well as fund managers from diverse banks as well as hedge funds. Example topics:

• How did shared beliefs, practices, ways of calculating, as well as technical systems touching on evaluation of asset-backed securities as well as CDOs earlier as well as during the credit crises?
• Was that Lucky or Good? Creating a framework for science attribution inward finance, describe of piece of occupation organization management as well as other risky endeavors.
• The “backing out” phenomena observed inward options markets:  how traders purpose models to imply independent variables consistent amongst marketplace observed pricing, as well as where plenty traders tin last incorrect virtually the expected results as well as the backed-out positions tin mail the incorrect message.

Sounds similar an interesting bird's core thought of quantitative finance.

How Produce You Lot Restrain Drawdown Using Kelly Formula?

As many of yous know, I am a fan of Kelly formula because it allows us to maximize long-term increment of equity acre minimizing the probability of ruin. However, what Kelly formula wont' preclude is a deep drawdown, though nosotros are assured that the drawdown won't last equally much equally 100%! This is unsatisfactory to many traders together with peculiarly fund managers, since a deep drawdown is psychologically painful together with may sweat yous to panic together with nigh downwards a strategy prematurely.

There is an slowly way, though, that yous tin role Kelly formula to boundary your drawdown to last much less than 100%. Suppose the optimal Kelly leverage of your strategy is determined to last K. And suppose yous solely let a maximum drawdown (measured from the high watermark, equally usual) to last D%. Then yous tin exactly gear upward aside D% of your initial total concern human relationship equity for trading, together with apply a leverage of one one thousand to this sub-account to decide your portfolio marketplace value. The other 1-D% of the concern human relationship volition last sitting inwards cash. You tin together with then last assured that yous won't lose all of the equity of this sub-account, or equivalently, yous won't endure a drawdown of to a greater extent than than D% inwards your total account. If your trading strategy is profitable together with the total concern human relationship equity reaches a novel high watermark, together with then yous tin reset your sub-account equity thus that it is i time again D% of the total equity, moving roughly cash dorsum to the "cash" account. Otherwise, yous proceed to hold the equity inwards the cash concern human relationship course of teaching from the equity of the trading sub-account.

Notice that because of this separation of accounts, this scheme is not equivalent to exactly using a leverage of L=K*D% on your total concern human relationship equity. Indeed, roughly of yous may last too nervous to role the total one one thousand equally leverage, together with prefer to role a leverage L smaller than K. (In fact, the mutual wisdom is that, due to estimation errors, it is never advisable to gear upward L to last to a greater extent than than K/2, i.e. half-Kelly.) The occupation alongside using a L that is too pocket-size is that, also non achieving maximum growth, the portfolio marketplace value volition last unresponsive to gains or losses together with volition stay relatively constant. Using the scheme I suggested higher upward volition cure this occupation equally well, because yous tin apply a higher leverage L_sub to the sub-account (e.g. role L_sub = L/D%) equally long equally L_sub < K, thus that the portfolio marketplace value is much to a greater extent than sensitive to your P&L acre however ensuring the drawdown volition non operate past times D%.

Has anyone tried this scheme inwards their actual trading? If so, I would last interested inwards hearing your sense together with encounter if do is equally proficient equally theory.

An Additional Etf Pair

Many of y'all know that at that spot are a seat out of dependable commodity-related ETF pairs that rest cointegrated ever since I mentioned them inwards 2006: IGE-EWC, IGE-EEM, IGE-EWA, EWA-EWC, etc. (Their latest zScores are available here to my book's readers as well as to Premium Content subscribers.) Influenza A virus subtype H5N1 recent view to a customer inwards South Africa prompted me to add together a novel one: EWA-EZA.

It is worth noting that for those province ETF pairs that cointegrate, their underlying currency cross-rates are oft stationary every bit well. Now, at that spot are several advantages inwards trading currency cross rates instead of ETF pairs. When trading a stationary cross rate, y'all tin operate inwards a restrain guild to operate inwards as well as exit, only trading pairs of ETF's involve marketplace orders on at to the lowest degree 1 side. Also, ETF's tin sometimes last hard-to-borrow, as well as their margin requirements are much to a greater extent than onerous than that of currencies. However, the 1 major disadvantage inwards trading cross rates is that they are non e'er available on your brokerage. For example, based on the cointegration of EWA as well as EZA y'all would intend that trading AUDZAR would last quite profitable. And y'all would last right, theoretically, except that AUDZAR is non available for trading on Interactive Brokers. If y'all know of a expert Forex brokerage that accept many emerging markets cross-rates for trading, peculiarly those of Latin American countries, delight permit the residuum of us know!

Are Flash Orders To Endure Blamed For Dow's 1,000 Points Drop?

Before the smoke is clear, fingers are already pointing at flash orders. See these 2 NYT pieces here as well as Madan has convinced me previously that flash orders tin indeed hold upwardly used to  front-run other traders, merely until to a greater extent than prove comes in, I am nonetheless to hold upwardly convinced that they are the principal culprit. Couldn't old-fashioned automated momentum programs accomplished the same affair subsequently an initial erroneous transaction toll and/or quote was reported? Perhaps yous know of discussions elsewhere on the blogosphere that convey to a greater extent than low-cal to the issue?

A Hft Primer

As a follow-up of my previous discussions on high frequency trading, I accept invited invitee blogger Jennifer Groton to portion alongside us a quick survey of diverse mutual HFT strategies used yesteryear equities too FX traders.

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High frequency trading strategies are nether fire.  The recent trading spike inwards our national exchanges was duly noted equally a short-circuit waiting to locomote on too drew immediate manufacture criticism of auto-trading robots. Before a witch-hunt ensues, perchance a review of the mutual HFT strategies inwards stocks too Forex is inwards order. 

High-frequency firms employ a broad diverseness of  low-margin trading strategies that are implemented yesteryear professional person marketplace position intermediaries who accept invested heavily inwards technology. These firms claim that they brand markets to a greater extent than efficient yesteryear enhancing liquidity too transparent cost regain to the create goodness of investors.  The Forex market’s unique combination of high liquidity too depression volatility instruct far an ideal environs for deploying HFT strategies, although many of the ideas too engineering scientific discipline are from the equity markets.  The basic strategies autumn into 3 categories: market-making, trending or predictive, too classic arbitrage.

Market-making strategies tend to focus on a unmarried stock or currency pair.  Many firms inwards this expanse accept been described equally engaging inwards "rebate-capture trading", a reference to the credits that firms instruct for providing liquidity on near marketplace position centers.

The instant grouping consists of mean-reversion too trending strategies. These utilize technical indicators for stocks or forex indicators for currencies, too essay to generate to a greater extent than provide from private trades.

The terminal grouping may ask a cross-section of trades from multiple markets.  The classic arbitrage strategy is a shape of the “carry trade” that uses the prices of a domestic bond, a bond denominated inwards a unusual currency, the spot cost of the currency, too the cost of a frontward contract on the currency.  If the marketplace position prices are sufficiently dissimilar from those implied inwards the model to encompass transactions costs, hence iv transactions tin hold upwards made to guarantee a risk-free profit.

High frequency trading is attributed alongside generating over 70% of the book of trades on our equity markets.  Similar statistics are non available for forex markets, precisely speculating disguised equally commercially necessary trades accept been reported to hold upwards over two-thirds of the volume.  Liquidity too pricing transparency are the benefits offered yesteryear its advocates, precisely regulators too other marketplace position participants who disagree alongside this positive assessment are shortly discounting these benefits.  Transaction taxes too fourth dimension limits on orders accept been proposed to mitigate the perceived direct a opportunity created yesteryear HFT firms, precisely the wheels of Washington motility slowly, fifty-fifty inwards crisis.  For the fourth dimension being, at that topographic point is no indication that their participation volition hold upwards discontinued.   

The Quants

Once inward a while, a mass well-nigh trading written for the full general world contains merely about useful nuggets fifty-fifty for professionals.  Kelly's formula, Universal Portfolios, in addition to the maximization of compounded increase rate. The Quants, yesteryear WSJ reporter Scott Patterson, is another. (Hat tip to my partner Steve for telling me well-nigh it.)

What is the most of import take-away inward The Quants? No, it is non that you lot should acquire to acquire a main poker histrion or chess histrion earlier hoping to buy the farm far big, though you lot would intend that given Patterson's exhaustive coverage of poker games played yesteryear the altitude quants. Among my ain professional person acquaintances, trader-poker-players are soundless a minority.

The most of import take-away is what ex-employees said well-nigh Renaissance Technologies: "there is no undercover formula for the fund's success, no magic code discovered decades agone yesteryear geniuses .... Rather, Madallion [Fund]'s squad of xc or in addition to then Ph.D.'s are constantly working to ameliorate the fund's systems, ..."

In other words, though you lot may non conduct maintain 90 Ph.D.'s  at your disposal, you lot tin soundless hap continuously improving/refining your strategies, improving the technology scientific discipline of your trading environment, in addition to increasing the multifariousness of your strategies. And though you lot may soundless non archive 60-70% annualized returns every year, you lot volition nonetheless savor stable returns yr afterwards year.

By the way, it is expert to meet my ex-colleagues Lalit Bahl, Vincent in addition to Stephen Della Pietra mentioned inward the book, all of whom left IBM to bring together Renaissance many years ago, in addition to who are extraordinarily overnice in addition to friendly guys, quite inward contrast to the norm on Wall Street.

Pair Trading Technologies Update

Pair trading was invented 2 decades ago, simply automating its implementation has solely of late boot the bucket stylish alongside independent traders. But i time the spotlight is on, innovations come upwards fast as well as furious. Here are a expose of recent developments that I notice interesting:


1. I mentioned previously the software called quant2ib. It is an API which allows us to acquire marketplace information as well as post orders from a Matlab programme to Interactive Brokers (IB). I possess got used it extensively for our trading, as well as it is every bit reliable every bit IB's native API. Their latest version straightaway includes functions for constructing a "combo" security. This combo safety tin strength out move pairs of stocks, ETF's, futures, etc. (with the notable exception of currencies), as well as the API allows y'all to acquire marketplace information every bit good every bit to submit orders on a combo. This is a huge improvement because y'all tin strength out straightaway automatically merchandise a yoke of securities every bit i unit of measurement yesteryear submitting limit orders on the combo. (Previously, y'all would possess got had to submit marketplace social club on at to the lowest degree i side of the pair, as well as this would possess got required your programme to continuously monitor the marketplace prices as well as post orders when appropriate. Or else y'all had to surrender using the API as well as manually come inward a "generic combo" boundary social club inward IB's TWS.)

2. Alphacet Discovery likewise has the mightiness to post boundary orders on pairs, due to its partnership alongside Knight Trading. Besides, based on a present that I possess got of late seen, they likewise straightaway possess got cracking pairs portfolio as well as execution reporting functionality. (Full disclosure: I used to consult for them.)

3. IB itself has released a "Scale Trader" algorithm that tin strength out move applied to combos (see 1. above. Hat tip: Mohamed.) I can't explicate this improve than their press release: "... ScaleTrader algorithm allows clients to exercise weather nether which a long seat inward i stock is built spell simultaneously creating an offsetting curt seat inward the other. The ScaleTrader is named because investors tin strength out 'scale-in' to marketplace weakness yesteryear setting orders to purchase every bit the marketplace moves lower. Similarly, sell orders tin strength out move 'scaled' into when a marketplace is rising. The ScaleTrader algorithm tin strength out move programmed to purchase the spread as well as afterwards possess got lucre yesteryear selling the spread if the deviation reaches predetermined levels ready yesteryear the user." In other words, it allows us to automatically implement the "parameterless trading" or the "averaging-in" strategy that I blogged well-nigh previously without whatsoever programming on our part!

Speaking of yoke trading, I volition move pedagogy my begin New York workshop inward October.  (My editor inevitably picks touristy locations for these workshops. My London workshop takes house across the street from the Tower of London, my New York workshop is across from the novel World Trade Center, as well as my Hong Kong workshop is inward the "Golden Mile" shopping district of Tsim Sha Tsui.)

What Are Nosotros To Produce Amongst Sharpe Ratio?

I wrote several times earlier how useless Sharpe ratio is for certainly types of strategies: run across here too here. Not only is a high Sharpe ratio quite useless inward telling y'all what harm extreme events tin hand the axe produce to your equity, a low Sharpe ratio is besides quite useless inward telling y'all what spectacular attain your strategy mightiness savour inward the outcome of a catastrophe. I came across roughly other vivid trial of the latter category inward the best-selling mass "The Big Short", where the writer tells of the even of the fund director Mike Burry.

Mike Burry started buying credit default swaps inward 2005, essentially an insurance policy on mortgage-backed securities, betting that at that spot volition hold upward widespread defaults on mortgages. Of course, nosotros straightaway know how this even would plow out: Mike Burry made $750 i 1000 one thousand inward 2007 alone.  But at that spot was zip but hurting for the fund director too his investors inward 2005-2006, since they had to pay an annual premium of 8% of the portfolio.  Investors who measured the functioning of this strategy using Sharpe ratio, without knowing the details of the strategy itself, would hold upward quite justified to mean value that it was an beak disaster prior to 2007. And indeed, many of them lost no fourth dimension inward trying to describe out their investments.

So what are nosotros to produce amongst Sharpe ratio, amongst its inherent reliance on Gaussian distributions? Clearly, it is useful for measure high frequency strategies which y'all tin hand the axe count on to generate consistent returns every day, but which has express catastrophic risks. But it is less useful for measure statistical arbitrage strategies that concord positions over multiple days, since at that spot may good hold upward substantial hidden catastrophic risks inward these strategies that would non hold upward revealed yesteryear their rails tape too measure difference of returns alone. As for strategies that are designed to produce goodness from catastrophes, such equally Mike Burry's CDS purchases or Nassim Taleb's options purchases, it is completely useless. If I were to allocate my assets over dissimilar hedge funds, I would hold upward certainly to include roughly funds inward the get-go category to generate cash flows for my daily needs, equally good equally funds inward the final category to produce goodness from the infrequent black-swan events. As for the funds inward the oculus category, I am increasingly losing my enthusiasm.

Phantom Quotes

Have you lot e'er got the feeling that your marketplace orders are oft filled at prices worse than the NBBO displayed on your trading screen? Apparently, this may hold upward the effect of deliberate manipulation of the marketplace yesteryear high frequency traders. These HF traders submit thousands of quotes per minute to the NYSE ("quote stuffing") together with and then cancel them inside 50 ms. This slows downwardly the central information queue thence much that yesteryear the fourth dimension a quote is transmitted to you, it is stale already, fifty-fifty if your trading server is collocated at the exchange. (Checking the fourth dimension postage stamp of the quote is of no help: the fourth dimension postage stamp is based on the fourth dimension the quote enters the queue, non when it exits the queue.)

If you lot tin no longer believe inwards the quotes, is at that spot whatever integrity left inwards the market? Much equally I intend that HFT may hold upward useful liquidity providers, I can't run into how this specific do could hold upward skillful for anyone over the long term.

(Hat tip: Jim Liew of Alpha Quant Club.)

Implementing Stock Strategies Using Options

There are many stock trading strategies that are quite attractive inwards price of Sharpe ratios, but non really attractive inwards price of returns. (Pairs trading comes to mind. But inwards general, whatsoever marketplace neutral strategy suffers from this problem.)  Certainly, i cannot feed a household unit of measurement amongst annualized returns inwards the unmarried or depression double digits, unless i already has millions of dollars of capital. One mode to solve this dilemma is of shape to bring together a proprietary trading group, where nosotros would get got access to perchance x30 leverage. Another mode is to implement a stock trading strategy using options instead, though at that spot are a sizable number of issues to consider. (I lately brushed upward on my options know-how past times reading the pop "Options equally a Strategic Investment".)

1. Using options volition allow y'all to increase your leverage beyond the Reg T x2 leverage (or fifty-fifty the solar daytime trading x4 leverage) alone if y'all purchase options only, but non selling them. For example, to implement a pairs trading strategy on two dissimilar stocks, y'all would get got to purchase telephone scream upward options on the long side, as well as buy put options on the brusk side (but non sell telephone scream upward options). Otherwise the margin requirement for selling calls is equally onerous equally shorting the underlying stock itself.
2. The effective leverage is computed past times multiplying the delta of the selection past times the underlying stock cost divided past times the selection premium. If y'all purchase an out-of-money (OTM) option, the delta volition live on small-scale (smaller than 0.5), but the selection premium is small-scale also. Vice versa for an in-the-money (ITM) option. So y'all would get got to detect the optimal nail cost then that the effective leverage is maximized. I personally lead to purchase an at-the-money (ATM) telephone scream upward or slightly ITM telephone scream upward without truly computing the optimized strike, but perchance y'all get got reached a dissimilar conclusion?
3. Naturally, the shorter the time-to-expiration, the cheaper the selection as well as higher the effective leverage. Additionally, for ITM options, their deltas increase equally nosotros become closer to expiration, which also contributes to higher effective leverage. However, the time-to-expiration must of shape live on longer than the expected belongings catamenia of your position, otherwise y'all would incur the transaction cost of rolling over to the further-month options.
4. The give-and-take of finding the correct nail cost based on its delta is moot if your brokerage's API does non render y'all amongst delta for your automated trading system. In theory, Interactive Brokers's API render deltas for whole options chains, as well as quant2ib's MATLAB API volition buy the farm these on to your MATLAB exeuction plan too. However, I get got non been successful inwards retrieving deltas using quant2ib's API. If y'all get got encountered a like problem, as well as perchance get got establish the reason/cure for this, delight allow me know. For now, I am reduced to assuming that all my around ATM calls for dissimilar stocks get got the same delta, as well as I increase this mutual value from 0.5 to some 1 equally fourth dimension passes.
5. Options don't get got MOO, LOO, MOC or LOC social club types. If i uses marketplace orders to purchase at the opened upward or close, i would incur pregnant transaction costs due to the much wider bid-ask spread compared to stocks. I motility to role throttle orders on options orders equally much equally possible.

If y'all get got used options to implement stock trading strategies, as well as get got experiences amongst these or other issues, delight produce percentage them here.

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Reminder: my side past times side pairs trading workshop volition get got house inwards New York on Oct 26-27th.

The Top Dog Virtue Of Buying Options

I realized that I accept omitted the most obvious virtue of trading options instead of stocks inwards my final post: the much to a greater extent than attractive reward-risk ratio for options.

Suppose your stock strategy generated a purchase signal. You tin either purchase the stock now, or yous tin purchase an ATM call. If yous purchase the stock, yous are of cast benefiting from 100% of the upside potential of the stock toll movement, only yous are similarly exposed to 100% of the downside risk. Indeed yous tin lose the entire marketplace value of the stock. If yous purchase the call, yous volition create goodness from > 50% of the upside potential of the stock price, assuming that your belongings current is together with then curt that the fourth dimension value volition non dissipate much. As the stock toll rises, together with then does your delta. (It increases from 0.5 to 1.) But what nigh the downside risk? All yous tin lose is the selection premium, unremarkably << 50% of the marketplace value of the stock.

In other words, piece 1 may last tempted to hedge a large stock pose amongst stock index futures, at that topographic point is no require to hedge an equivalent telephone band selection position. This should simplify your strategy implementation together with trim back direct chances management costs (i.e. the belike loss on your curt futures position).

Given that I am a short-term trader anyway, I can't figure out why I accept been trading stocks instead of options all these years! (Aside from the caveats detailed inwards the previous post.)

Data Mining In Addition To Artificial Word Update

Long fourth dimension readers of this spider web log know that I haven't constitute data mining or artificial intelligence techniques to live on real useful for my ain trading, for they typically overfit to non-recurring past times patterns. (Not surprisingly, they are much to a greater extent than useful for driverless cars.) Nevertheless, i must maintain an opened upward heed together with continues to maintain tabs on novel developments inwards this field.

To this end, here is a novel newspaper written past times an technology scientific discipline pupil at UC Berkeley which uses "support
vector machine" together amongst 10 uncomplicated technical indicators to predict the SPX index, purportedly amongst 60% accuracy. If i includes an additional indicator which measures the lay out of word articles on a stock inwards the previous day, thence the accuracy supposedly goes upward to 70%.

I did non accept the peril to reproduce together with verify this consequence yet, precisely I invite y'all to essay it out together with percentage your findings here. If y'all arrive at so, y'all may notice this novel information mining production called 11Ants Analytics useful. It is an Excel-based software that includes 11 machine learning algorithms including the aforementioned back upward vector machines. It equally good includes determination trees which are sometimes quite useful inwards automatically generating a small-scale laid upward of trading rules from an input laid upward of technical indicators. (Whether those rules rest profitable inwards the time to come is some other question!) If y'all accept tried this product, I would equally good appreciate your comments here.

(If y'all are a die-hard MATLAB fan, back upward vector machines are available inwards their Bioinformatics Toolbox, together with classification together with determination trees inwards their Statistics Toolbox.)

Columbia Workshop On Fiscal Engineering

Our readers inwards New York may hold upwards interested inwards this finance workshop at Columbia University tomorrow.
I am especially interested inwards the beak past times Kent Daniel on "Characterizing Momentum", together with past times Doug Borden (of Knight Equity Markets) on "Stochastic Control Theory inwards High-Frequency Trading". Doug's beak tin hold upwards downloaded here.

Shorting The Vix Calendar Spread

Lately in that location were a few interesting discussions inward the blogosphere on the profitability of shorting the VXX-VXZ spread. (See Quantum Blog in addition to The Speculator's Ball.) For background, VXX is an ETN that tracks the showtime in addition to minute calendar month of the VIX future, which inward plow tracks the VIX volatility index, which inward plow tracks the volatility of SPX. VXZ is the ETN that tracks the fourth - seventh months of the VIX future. During the menstruum 2009-2010, in that location were two dissimilar reasons why shorting this "calendar spread" was profitable:

1) The VIX futures were/are inward contango: i.e. the dorsum months' futures are to a greater extent than expensive than the front end months'.
2) The volatility of SPX was decreasing alongside time.

However, unopen to traders appear to intend that either 1 of these weather is plenty to ensure the profitability of shorting a calendar spread.  It is not. (Otherwise, life every bit a futures trader would endure also easy!)

To run into this, let's resort to a simplistic linear approximation to a model of futures prices. From John Hull's mass on derivatives, department 3.12, the cost of  a futurity which matures at fourth dimension T is

F(t, T)=E(ST)exp(c(T-t)),

where E(ST) is the expected value of the spot cost at maturity, c is a constant, in addition to t is the electrical flow time. If the futures are inward contango, hence c > 0.

If nosotros assume that abs(c) is small, in addition to T-t is also modest (i.e. non also far from maturity), in addition to that the expected value of the spot cost changes slowly, nosotros tin linearize this formula as

F=(a+b(T-t))*(1+c(T-t))

If the marketplace expects the futurity spot cost to increase, hence b > 0.

After a few elementary algebraic steps, you lot tin verify that the calendar spread's cost is proportional to

F(t, T1)-F(t, T2)  bct

where T1 < T2 (i.e. F(t, T1) is the front end month's price, and F(t, T2) the dorsum month's).

This is a satisfyingly illustrative result. It says that shorting this calendar spread volition endure profitable if

A) futures are inward contango and the expected spot cost inward the futurity is decreasing; or else
B) futures are inward backwardation and the expected spot cost inward the futurity is increasing.

So what is the province of affairs today? Will it all the same endure profitable to brusk this spread? As our beau bloggers accept pointed out, VIX futures are all the same inward contango, exactly the marketplace is expecting volatility to increment inward the futurity over the concluding calendar month or so. So this may no longer endure a profitable merchandise anymore.

High Frequency Trading Ideas

I but started reading Larry Harris' mass "Trading as well as Exchanges" (thanks to Max Dama's glowing mass review) as well as already a brace of potential high frequency trading techniques stood out:

"Quote matching" - a technique whereby front-runners house a trammel purchase gild but a cent (for stocks) higher than the best bid price. If the gild is filled, they as well as then house a trammel sell gild but a cent lower than the best ask. Assuming the best bid-ask quotes don't move, the worst they tin create is to lose 1 cent by selling the percentage dorsum to the best bidder, piece the nearly net they tin brand is the bid-ask spread plus rebates for providing liquidity minus two cents yesteryear having the sell long trammel gild filled. This could run out quite profitably if the bid-ask spread is wide. But of course, the best bid-ask create alter constantly, thence front-runners would demand to cancel as well as right their trammel orders constantly, as well as the optimal algorithm for doing this could teach quite complicated. Meanwhile, if yous are a bona fide liquidity provider, yous would bring to avoid providing this gratuitous pick to the front-runners yesteryear constantly monitoring who is inwards front end of you. As usual, this chess game tin chop-chop degenerate into an HFT arms race.

"Manipulation of halt orders" - a.k.a. "gunning the market", a technique whereby the marketplace gunners purchase aggressively thence equally to trigger large purchase halt orders that they believe are inwards house at a higher price. When these purchase halt orders are filled, the prices are driven higher still, as well as these manipulators as well as then sell their position profitably.

One of my one-time momentum strategies was a victim of these marketplace gunners, as well as afterwards that lamentable sense I refused to role halt orders whatever more, at to the lowest degree for stocks. However, hither is a enquiry for our knowledgeable readers: tin other traders truly meet what halt orders at that topographic point are on an gild mass (whether for stocks, futures, or Forex markets)? And if so, would a trading robot that simulates halt orders yesteryear sending out purchase marketplace orders when the halt toll is touched run improve than manually placing a purchase halt gild on the gild book?

Momentum Strategies Inwards Futures Together With Forex

I bring long establish that it is easier to uncovering practiced (i.e. high Sharpe ratio) mean-reverting strategies than practiced momentum strategies. Partly, that is because I was mainly a stock trader instead of a futures/currencies trader, in addition to private stocks mean-revert most of the time. There are exceptions, such every bit later on special corporate events such every bit earnings announcements, in addition to I bring tested momentum strategies based on these events. But the success of fifty-fifty these event-driven strategies has been uneven, specially since to a greater extent than traders larn aware of them.

Now that I am focusing to a greater extent than on trading futures in addition to currencies, I bring gradually been introduced to the basis of momentum investing. There is a practiced mass inward this expanse that deserves to last improve known: Joe Duffy's The Ultimate Trading Robot, which is an nearly step-by-step direct to constructing futures trending strategies that rely on prices alone. Another instance would last the London Breakout strategy mentioned past times our reader Bernd inward the comments here. After studying these examples, I realized why my previous, rather desultory, search for momentum strategies inward the futures in addition to FX markets had been inward vain: the overnight gap inward these markets seems critical. For futures, the overnight gap is obvious, simply inward the instance of the London Breakout strategy, for example, the trader has the chore defining for herself what the optimal closing in addition to opening times are inward club to compute the gap. Intraday tendency without an overnight breakout does non appear persistent plenty to last traded profitably. I likewise wonder if at that topographic point is a to a greater extent than elegant (i.e. mathematical) style to quantify such breakout phenomena without using the traditional technical indicators.

If yous know of ideas for practiced momentum strategies, yous are most welcome to portion in addition to hash out them here!

The Many Facets Of Linear Regression

Many years ago, a portfolio managing director asked me inwards a telephone interview: "Do you lot believe that linear or nonlinear models are to a greater extent than powerful inwards edifice trading models?" Being a babe-in-the-woods, I did non hesitate inwards answering "Nonlinear!" Little did I know that this is the inquiry that dissever the men from the boys inwards the realm of quantitative trading. Subsequent experiences showed me that nonlinear models accept mostly been unmitigated disasters inwards terms of trading profits. As Max Dama said inwards a recent first-class article on linear regression: "...when the signal to racket ratio is .05:1, ... there’s non much betoken inwards worrying nearly [higher gild effects]". One is almost sure enough to overfit a nonlinear model to non-recurring noise.


Until recently, I accept used linear regression mainly inwards finding hedge ratios betwixt ii instruments inwards couplet trading, or to a greater extent than to a greater extent oft than non inwards finding the weightings (in publish of shares) of private stocks inwards a handbasket inwards closed to shape of index arbitrage. Of course, others accept found linear algebra useful inwards principal ingredient analysis in addition to to a greater extent than to a greater extent oft than non cistron analysis every bit well. But cheers to a publish of commenters on this weblog every bit good every bit diverse private correspondents, I accept begun to apply linear regression to a greater extent than straight inwards trading models.


One way to straight apply linear regression to trading is to piece of occupation it inwards house of moving averages. Using moving average implicitly assumes that at that topographic point is no tendency inwards a cost series, that the hateful of the prices volition rest the same. This of class may non live on true. So using linear regression to projection the electrical flow equilibrium cost is sometimes to a greater extent than accurate than simply setting it equal to a moving average. I accept found that inwards closed to cases, this equilibrium cost results inwards improve mean-reverting models: e.g. curt an musical instrument when its electrical flow cost is way to a higher house the equilibrium price. Of course, 1 tin strength out too piece of occupation linear regression inwards a similar way inwards momentum models: e.g. if the electrical flow cost is way to a higher house the equilibrium price, take in this a "breakout" in addition to purchase the instrument. 


Max inwards his article referenced to a higher house too pointed out a to a greater extent than sophisticated version of linear regression, normally called "weighted to the lowest degree squares regression" (WLS). WLS is to linear regression what exponential moving average (EMA) is to elementary moving average (SMA): it gives to a greater extent than weights to recent information points. Indeed I accept found that EMA oft gives improve results than SMA inwards trading. However, in addition to thence far I accept non found WLS to live on improve than elementary to the lowest degree squares. Max too referenced an article which establishes the equivalence betwixt weighted to the lowest degree squares in addition to Kalman filter. Now Kalman filter is a linear model that is really pop with quantitative traders. The squeamish characteristic nearly Kalman filter is that at that topographic point is really few gratis parameters: the model volition conform itself to the agency in addition to covariances of the input fourth dimension serial gradually. And furthermore, it tin strength out exercise in addition to thence one-step at a time (or inwards technical jargon, using an "online" algorithm) : i.e., at that topographic point is no demand to dissever the information into "training" in addition to "test" sets, in addition to no demand to define a "lookback" menses dissimilar moving averages. It makes piece of occupation of "hidden states" much similar Hidden Markov Models (HHM), but dissimilar HHM, Kalman filter is faithfully linear.


I haven't used Kalman filter much myself, but I would welcome whatsoever comments from our readers on its usage. Also, if you lot know of other ways to piece of occupation linear regression inwards trading, exercise part with us here!

Time-Of-Day Effects Inwards Fx Trading

As I mentioned inward a previous post, ane of the master copy ingredients of success inward constructing a profitable momentum trading strategy inward Forex (and futures) is to pay attending to the entry as well as leave of absence times. I haven't seen whatever practiced momentum strategy that has "time-translation invariance", i.e. works without reference to a fixed fourth dimension of the day. The fixed fourth dimension tin refer to a benchmark grade of the marketplace (e.g. the previous close), or it tin hold upwards the entry or leave of absence time.  (This is inward contrast to mean-reverting strategies where the reference cost tin oftentimes hold upwards only a moving average.) A recent inquiry paper (Hat tip: William) points to only about other example of such time-of-day effects inward FX markets: a currency typically depreciates during its local trading hours.

A Platform, A Shareware Site, As Well As Roughly Courses For Quant Traders

I mentioned inwards diverse places that Alphacet Discovery is an industrial trace integrated platform for backtesting in addition to implementing quantitative trading strategies. But of course, it has many competitors, 1 of which is a relatively novel fellowship called Deltix. Deltix has the distinction of offering a amount Matlab interface, which is convenient if you lot are already a Matlab programmer. (Full disclosure: I previously convey a consulting human relationship alongside Alphacet, simply convey none alongside Deltix.)

There is too a novel website for sharing trading strategy software called Quantonomics. In the words of its founder Joshua, the destination is to "connect programmers in addition to stock traders". Joshua too told me that he volition practise a custom application on his site for whatsoever of you lot readers every bit a gift!

Influenza A virus subtype H5N1 colleague of mine inwards Singapore, medico Li Haksun, who was previously a quant alongside UBS in addition to BNP Paribas, is offering a course on quantitative trading strategy in July. It covers to a greater extent than theoretical concepts than my ain courses: e.g. hidden markov model, stochastic control, in addition to Kalman filters are included.

And of course, my ain workshops on Backtesting in addition to Statistical Arbitrage volition move offered in 1 trial again inwards London side past times side week.

Even To A Greater Extent Than On Intelligence Driven Trading

News driven trading is fifty-fifty to a greater extent than inwards style today than when I lastly mentioned it, judging from the increasing reveal of vendors (e.g. Ravenpack, Sensobeat, Recorded Future, etc.) in addition to researchers pitching their wares. Not alone are traditional fiscal in addition to economical intelligence deemed important, only researchers accept flora fifty-fifty spider web log posts (at to the lowest degree those on Seeking Alpha) in addition to Twitter (Hat tip: Satya in addition to William) to live predictive of stock prices.

One cardinal cistron to success inwards this type of trading is of course of teaching the might to make access to breaking intelligence ahead of other traders. On the macroeconomic intelligence front, the MIT Billion Prices projection has spun off a companionship called PriceStats to deliver daily consumer production toll index to subscribers. PriceStats compiles this index past times continuously scanning online retailers' websites, in addition to hopefully provides a preview of the official CPI numbers. Whether this is useful for futures in addition to currencies traders is of course of teaching dependent champaign to their rigorous backtests, though the chart displayed on their website does propose that the daily toll index is a leading indicator of the CPI.

There is an of import caveat to using intelligence trading: non all intelligence are equal. So to a greater extent than or less other cardinal cistron to success is to carefully differentiate betwixt the dissimilar types of intelligence in addition to backtest their predictive abilities separately. For example, I recollect to a greater extent than or less enquiry has indicated that an analyst downgrade of a stock from a "hold" to a "sell" rating has to a greater extent than affect than from "buy" to "hold" rating.

My ain sense amongst intelligence driven trading is that for all this trouble, the trading opportunities are relatively few compared to pure toll driven trading, the consistency of success is low, in addition to finally the profitability lifespan is short. If yous accept amend experience, produce part it amongst us.

When Cointegration Of A Duet Breaks Down

I accept written a lot inwards the past times most the cointegration of ETF pairs, as well as how this status tin Pb to profitable pairs trading. However, equally every investment advisor could accept told you, past times cointegration is no guarantee of hereafter cointegration. Often, cointegration for a couplet breaks downwards for an extended period, possibly equally long equally a one-half a twelvemonth or more. Naturally, trading this couplet during this catamenia is a losing proposition, but abandoning such a couplet completely is also unsatisfactory, since cointegration oft mysteriously returns afterwards a while.

Influenza A virus subtype H5N1 instance inwards betoken is the ETF couplet GLD-GDX. When I starting fourth dimension tested it inwards 2006, it was an first-class candidate for couplet trading, as well as I non exclusively traded it inwards my personal portfolio, but nosotros traded it inwards our fund too. Unfortunately, it went haywire inwards 2008. We promptly abandoned it, exclusively to come across the strategy recovered sharply inwards 2007.

So the big interrogation is: how produce nosotros know whether the loss of cointegration is temporary, as well as how produce nosotros know when to resume trading a pair?

To response the starting fourth dimension question, it is oft necessary to acquire beyond the technicals, as well as delve into the fundamentals of pair. Take GLD-GDX equally the example. When I taught my pairs trading workshop inwards South Africa, several  portfolio managers inwards attendance told me that in that location are two reasons why gilded location toll diverged from gilded miners' stock prices. Firstly, due to the sudden increase inwards fossil oil prices during the starting fourth dimension one-half of 2008, it costs the gilded miners a lot to a greater extent than inwards unloosen energy to extract the gilded from the ground, therefore the gilded miners' income lags behind the ascent inwards gilded prices. Secondly, many gilded miners hedge their exposure to fluctuating gilded prices amongst derivatives. Hence when gilded toll ascent beyond a for certain limit, the gilded miners cease to produce goodness from this rise. Recently, the Economist magazine published an article that essentially confirms this view. But farther confirmation tin hold upward gained past times introducing fossil oil (future) toll into the cointegration equation. If you lot produce that, as well as if you lot merchandise this triplet of GLD-GDX-USO, you lot volition discovery that it is profitable throughout the entire catamenia from 2006-2010. If you lot discovery trading a triplet also complicated, you lot tin at to the lowest degree backtest a trading filter such that you lot volition cease to merchandise GLD-GDX whenever USO goes beyond (above, as well as possibly below too) a for certain band. If you lot accept done all these backtests, you lot volition accept a invention inwards house to enjoin you lot when to resume trading this pair. But fifty-fifty if you lot haven't done this backtest, as well as you lot discovery that you lot ask to halt trading a couplet because of cumulating losses, you lot should at to the lowest degree maintain paper trading it to come across when it is turning around!

(By the way, if you lot mean value trading ETF pairs offers also depression returns due to the depression leverage allowed, reckon the unmarried stock futures on ETF's trading on the OneChicago exchange. Certainly the hereafter on GDX is available there, spell you lot powerfulness simply merchandise the futures GC as well as CL straight on CME. There is, of course, the commons caveat that applies to futures pairs trading: the switch from contango to backwardation as well as vice versa tin ruin many a pairs-trading strategy, fifty-fifty if the location prices rest cointegrating. But that's a even out for simply about other time.)

Hedge Fund Transparency As Well As Barometers

Jim Liew of Alpha Quant Club late posted an interesting article close the increasing postulate for transparency of hedge fund strategies yesteryear institutional investors, as well as then much as well as then that they are essentially willing to invest solely inward managed accounts amongst real-time trades as well as positions updates. This is, of course, bad for fund managers, since non solely tin flaming the investor reverse-engineer the simpler strategies from such knowledge, they tin flaming every bit good piggy-back on the trades, hence paying a much smaller component of their profits every bit surgical procedure fee. One mightiness live on tempted to mean value that since the investors are going to reverse-engineer the production anyway, why non simply become far every bit elementary as well as every bit generic every bit possible, as well as accuse a much lower fee than the commons 2-20 (which hopefully volition attract a much larger investor base), as well as then that the primary value to the investor is simply convenience as well as non the originality of the strategy?

In fact, Jim wants to produce simply that. He proposes to build hedge fund "barometers", essentially prototypical hedge fund strategies running inward managed accounts. This would move good if these barometers convey large plenty capacities such that the surgical procedure tin flaming concur upwards fifty-fifty when a large set out of investors sign up. From the investors' indicate of view, this is a trade-off betwixt investing inward a genuinely outstanding, high-performance strategy piece paying a large fee as well as losing "transparency", versus simply investing inward a generic strategy that may notwithstanding outperform the wide market. For some institutional investors, this mightiness simply live on the grapple they are looking for.

The Social Utility Of Hedge Funds

There is an article inwards the New Yorker magazine profiling Bridgewater Associates, the world's biggest global macro hedge fund. Inevitably, nosotros come upwards to the awkward question: "If hedge-fund managers are playing a zero-sum game, what is their social utility?"


I idea virtually this query a lot inwards the past, and I used to handgrip amongst many others that the social utility of hedge funds, or trading inwards general, is to supply liquidity to the markets. And a expert economical representative tin hold upwards made that the to a greater extent than liquid a marketplace is, the higher the utility it is to all participants. However, based on recent experience of flash crash together with other unfortunate mishaps, nosotros uncovering out that traders typically create not supply liquidity when it is needed most! So this response becomes quite unsatisfactory.


In trying to come upwards up amongst a meliorate reply, I though it is curious that few people asked "What is the role of having a Department of Defence?" since wars betwixt nations are typically also zero-sum games, soundless nosotros greatly accolade those who serve inwards the military machine (in contrast to our feelings for hedge fund managers).


To me, clearly the response amongst the best moral justification is that, inwards both cases, at that spot is dandy social utility inwards defending either your clients' comfortable retirement from fiscal meltdown (e.g. due to governmental or corporate mismanagement), or inwards defending your province from unusual aggression. More specifically, the role of hedge funds is to trim back long-term volatility in your clients' cyberspace worth. (I would similar to tell "reduce risks to your clients' cyberspace worth", but that would hold upwards a chip also optimistic!) 


I emphasize long-term volatility, because of course of study trading generates a lot of daily or hourly volatility inwards your clients' equity. But I create non believe that such short-term volatility affects ones' life goals. On the other hand, a 3-or-more-year drawdown inwards a typical buy-and-hold portfolio tin wreck havoc amongst many lives.

If ane day, the markets expire hence quiescent that few hedge funds tin generate higher Sharpe ratio than a buy-and-hold portfolio (as indeed seems to hold upwards the representative amongst the USA equities markets these days), together with hence yes, most hedge fund managers should simply quit, instead of hogging intellectual resources from our best universities.

Sorry, Your Supply Is Also High For Us

I enjoyed reading Richard Wilson's The Hedge Fund Book (Richard also runs the Hedge Fund Blogger site). To travel clear: it is purely marketing-oriented. It doesn't nation you lot how to discovery a successful trading strategy, but its focus is to nation you lot how to marketplace your fund to investors i time you lot accept a successful strategy. To that end, it does a pretty skilful chore inwards conveying what powerfulness travel conventional wisdom to seasoned fund managers. (For e.g., don't bother to marketplace to institutional investors if your AUM is less than $100M.) The majority is filled amongst quite engaging interviews amongst fund managers, fund marketers, as well as other fund service providers (including our really ain administrator Fund Associates). If Scott Patterson's The Quants is most the gods of hedge funds, this majority is for as well as most the mortals.

One paragraph inwards the majority stood out: "I've worked closely on the third-party marketing as well as uppercase introduction/prime brokerage side of the business, as well as I oft meet both types of firms deny clients service [to funds amongst high returns as well as high risk] ... Nobody wants to travel associated amongst a director aiming at thirty percentage a calendar month returns."

Maybe non aiming at, but what's incorrect amongst achieving a thirty percentage a calendar month returns? I accept genuinely met institutional investors who don't wishing to await at a fund that genuinely achieved double-digit monthly returns. Presumably that's because they believe that a high render automatically implies high risk, as well as also presumably a high leverage every bit well.  I would debate that at that topographic point are two reasons non to completely dismiss such funds out-of-hand:

1) Leverage should non travel determined arbitrarily, but should travel based on the minimum of what's dictated past times half-Kelly (see my extensive discussions of Kelly formula on this weblog as well as inwards my book) as well as what's dictated past times the maximum single-day drawdown seen historically or inwards VaR simulations. And if this minimum nonetheless turns out to travel higher than what most institutional investors are comfortable with, i should travel bold plenty to adopt it inwards your fund.

2) As an investor, at that topographic point is an slow mode to command leverage as well as risk: simply apply Constant Proportion Portfolio Insurance (a concept also discussed elsewhere on this blog). For example, if the fund director tells you lot the fund employs a constant 10x leverage (as dictated past times the run a endangerment analysis outlined inwards 1) as well as you lot are entirely comfortable amongst 5x leverage, simply invest one-half your uppercase into the fund, as well as proceed the other one-half every bit cash inwards your banking concern account! Going forward, if the fund loses money, your effective leverage would accept decreased to below 5x. Say you lot invested $1M into the fund, as well as kept $1M inwards the bank. And nation the fund lost $0.5M. Your full equity is at nowadays $1.5M, as well as the fund director is supposed to merchandise a $0.5M*10=$5M portfolio. Your effective leverage is at nowadays entirely 3.33x, good inside your tolerance. Now if instead, the fund made money, you lot tin give notice directly take roughly of the profits to proceed your effective leverage at 5x. So, nation the fund made $0.5M. Your equity is at nowadays $2.5M, as well as the fund director is supposed to merchandise a $1.5M*10=$15M portfolio. If you lot don't withdraw, this would growth your effective leverage to 6x. But if you lot directly take $0.25M, as well as then the fund director volition merchandise a $1.25M*10=$12.5M portfolio, giving you lot an effective leverage of the desired 5x.

If you lot are an investor inwards hedge funds, delight allow us know what you lot intend of this system inwards the comments section!

More On Automated Trading Platforms

The ideal software platform for automating backtesting too executing your algorithmic trading strategies depends mainly on your degree of programming expertise too your budget. If you lot are a competent programmer in, say, Java or C#, at that spot is goose egg to preclude you lot from utilizing the API offered (usually for free) past times many brokerages to automate execution. And of course, it is too slow for you lot to write a sort backtesting programme utilizing historical data. However, fifty-fifty for programmer-traders, at that spot are a couplet of inconveniences inwards developing these programs from scratch:

A) Every fourth dimension nosotros alter brokerages, nosotros stimulate got to re-write parts of the low-level functions that utilize the brokerage's API;

B) The automated trading programme cannot endure used to backtest unless a simulator is built to feed the historical information into the programme every bit if they were live. To bring down bugs, it is amend to stimulate got the same code that both backtests too trades live.

This is where a reveal of open-source algorithmic trading evolution platforms come upward in. These platforms all assume that the user is a Java programmer. But they eliminate the hassles A) too B) higher upward every bit they serve every bit the layer that shield you lot from the details of the brokerage's API, too allow you lot larn from backtesting to alive trading fashion amongst a figurative plough of a key. I stimulate got taken a tour of ane such platforms Marketcetera, too volition highlight around features here:

1) It has a trading GUI amongst features like to that of IB's TWS. This volition endure useful if your ain brokerage's GUI is dysfunctional.

2) Complex Event Processing (CEP) is available every bit a module. CEP is essentially a agency for you lot to easily specify what sort of market/pricing events should trigger a trading action. For e.g., "BUY if inquire toll is below 20-min moving average." Of course, you lot could stimulate got written this trading dominion inwards a callback function, only to shout out upward the 20-min MA on-demand could endure quite messy. CEP solves that information retrieval occupation for you lot past times storing exclusively those information that is needed past times your registered trading rules.

3) It tin utilisation either FIX or a brokerage's API for connection. Available brokerage connectors include Interactive Brokers too Lime Brokerage.

4) It offers a intelligence feed, which tin endure used past times your trading algorithms to trigger trading actions if you lot utilisation Java's string processing utilities to parse the stories properly.

5) The monthly cost ranges from $3,500 - $4,500.

If Marketcera is beyond your budget, you lot tin banking concern lucifer out AlgoTrader. It has advantages 1)-3) only non 4) listed above, too is completely free. I invite readers who stimulate got tried these or other like automated trading platforms to comment their user sense here.

P.S. For those of us who utilisation Matlab to automate our executions, a reader pointed out at that spot is a novel production MATTICK that allows you lot to mail gild via the FIX protocol which should allow us merchandise amongst a slap-up diversity of brokerages.