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Foundations

Concepts: Developing a Quantitative Trading Strategy – The Foundation (Part 2)

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Part 2 of our series on how to develop a quantitative or algo trading strategy.

An Idea can change your life. This was the tag-line for cellular mobile operator Idea before it merged with Vodafone to become Vodafone Idea. Ideas are a dime a dozen, Execution is not. 

Investors and Traders breeze into the market with basically no idea other than that they see this as an easy way to generate wealth and Income, yours truly included. Yet, like a mirage in a Desert, it’s only after experience that one learns that this is one of the hardest professions out there.

How one gets introduced into markets plays a large role in how the investor builds his views and biases. Those who come with an education such as a Masters Degree in Finance for example have a different world view than those whose entry was through a broker who day trades for a living.

While starting points may differ, long term success of the investor is dependent upon how he evolves over time. We learn new things, un-learn some bad learnings, re-learn new things before finally committing ourselves to beliefs that we believe are valuable and one that could be applied through the life. 

As an investor or a trader, you basically face two choices – should you go with your gut instincts based on data – visual generally speaking or should you leave your brains behind and go systematic and do what the system says you to do.

When we lack a strategy, we tend to go with our feelings and this leads to most us falling prey to various biases that causes more harm than good. From anchoring bias to sunk cost fallacy, we knowingly or unknowingly fall to traps that our own minds set up for us. 

A person needs to study medicine for 6 years before he is allowed to prescribe medicine to a patient, a lawyer puts in 5 years of study, a civil engineer studies 4 years. Art students polish up their skills over multiple years. The most famous painter of all, Leonardo da Vinci is supposed to have spent a total of 7 years, not exclusively, on painting the world famous Mona Lisa.

Yet, as Investors and traders, we believe the market owes to us and success shouldn’t be difficult to achieve – all without much of any formal education to provide us with a foundation.   

Starting with a Plan

Whether you are an investor who is new to markets or some one who has seen the cycles, the one thing that is required to achieve success of even a moderate nature is a plan of action. A plan is not just about what one intends to achieve but also the path one is willing to take and the way one will ascertain the results.

There is no dearth of literature when it comes to Investing, yet most investors barely achieve success worth talking about. Most of us can come up easily with the top 10 cricket players of all time who achieved unparalleled fame and success. Try coming up with top 5 investors who you would like to emulate.

In his book, Outliers, Malcolm Gladwell writes about the 10,000-Hour Rule. Gladwell says that research has even settled on the “magic number” of hours it takes to achieve expertise: it is 10,000 hours.

If you are a sportsman wishing to succeed in your chosen field, this may translate to working hard, practising more among others. But when it comes to investing, how do you apply such a Rule?

Spending hours starting at charts or balance sheets can help you get a perspective, but could that lead to success?  

Investing and Trading like Chess is more of a mental game than one where the winner has a better body structure or style. This also means that while reading helps, deep thinking is an absolute necessary so that you can come up with a frame work with which to operate.

Having a strong philosophy around which you will build your system is critical for success for every strategy goes through tough times and the only way to avoid jumping out at the worst possible time is to have a strong belief backed by historical evidence that the strategy in itself isn’t bad but the current time is.

As much as enticing Systematic Investing / Trading could be, there are a couple of pre-requisites. 

Introduction to Technical Analysis:

Purists of the Quant would laugh off about Technical Analysis and Quantitative Strategy building, but if we are to build systems around price, it is very important that we have a good understanding of Technical Analysis, especially of the non discretionary variety.

If you are exposed to Television, you would have been introduced to Charts. Technical Analysis is the study of supply and demand forces as reflected in the market price movements of a security.

At its basic, we can divide Technical Analysis into two parts – Subjective and Objective. Subjective is looking at charts and trying to find patterns that one believes can foretell the future. It’s closer to Art and Astrology than Science. Yet, thanks to our own biases and ability to see only those patterns that succeeded or we wish to see.

Subjective Technical Analysis is much more famous for it allows the analysts to spin narratives based on his own biases. 

Objective Technical Analysis on the other hand is closer to Maths. The answers are all binary in the sense that something can either be True or False and nothing else. Two Analysts may or may not agree with a Subjective view of a chart, but with Objective, you are bound to agree.

Quantitative strategies don’t need any help from Technical Analysis for we are looking basically at numbers and trying to draw conclusions from it. Yet, knowledge of technical analysis and its weakness can be of tremendous help in constituting filters that reduce trades and even false signals.

As a subject, Technical Analysis is too big and wide to be described fully in a post such as this. Instead, I would recommend that you check out the following books.

The first book that provides you with a framework around technical analysis is Technical Trends by Edward and Magee. This provides a platform for you to grasp the various semantics.

The second and more important book I would recommend checking out is Evidence–Based Technical Analysis by David Aronson. Technical Analysis will be the base on which we shall showcase how to go about building systems, bet if for short term trading or long term buy and hold.

These two books should ideally provide you with a strong framework and help you get a leg up on how markets behave and the opportunities it may present. 

Quantitative strategies are all about Rules. Rules that either carry value or not. We shall leave the discretionary for the Artists.

Ability to Code and Massage Data

20 years ago, data availability was tough which meant that you could work on the same without having to resort to coding. Today, there has been an explosion of data that is easily available and the only way you can handle the same is with code.

You don’t need to be a software engineer but at the same time, understanding and being able to code basic level programs can go a long way in mitigating the otherwise tough world of data.

In addition to the above, Interest in Human Behavior, History and Statistics can go a long way in helping you understand where you stand and understanding the points of failure.

The Basics 

Before we begin modelling, we need to figure out a few basics. 

The time frame for instance plays a very important role in the kind of system you want to build. In the extreme short term, you can for instance run mean reversion based strategies though as you go higher through the time frame, following the trend offers a better risk reward.

Mean Reversion requires a thought process that is diametrically opposite to the one required for trend following. We shall look at ideas from both ends of the Spectrum. 

Think of mean reversion as: If this stock goes up too much, it is now more likely to come down. This happens more often in intraday or short term strategies. 

Think of trend following as: if this stock goes up too much, it’s likely to go up even more. A slightly longer term – days to weeks to months – is needed for a trend to build. 

One key factor that plays a major role in deciding the style and time frame is the capital you wish to deploy. Smaller capital can be deployed in both short and long term time frame strategies, but once you exceed a certain amount of capital, going higher on the time frame is helpful – at least till you experience enough that you believe that you know what you are doing & willing to bet it all on bigger position sizes at small time frames.

There is a whole lot of interest in Systematic / Algorithmic Trading since for many it seems like a quick and easy path for success in markets. While that may have been true a couple of decades ago when there was a lot of such opportunities, these have dwindled to the extent that even pre-fees many a strategy that may have been profitable earlier would now result in losses.

Being systematic also requires a change of mindset. You would need to leave out of the front door all the economic forecasts, the stock / sector predictions and even your view about stocks in the portfolio. All you need to do is to be able to stick to the process you have committed for yourself.

If you are game for this, you would love to get a hold on how to go about building your first systematic strategy, testing it and finally executing the same. 

In our next post, we shall look at the starting point for any research to begin – Data. 

Data is the new Oil they say, and for a systematic investor / trader, Data is the only thing that matters – Clean Data that is. We shall look at that as we start the process of collating the next piece of the puzzle. We’ll build a system, but first, we’ll ensure our data itself is good enough for this system to be tested.  

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