Have you ever got the feeling that your market orders are often filled at prices worse than the NBBO displayed on your trading screen? Apparently, this may be the result of deliberate manipulation of the market by high frequency traders. These HF traders submit thousands of quotes per second to the NYSE ("quote stuffing") and then cancel them within 50 ms. This slows down the exchange data queue so much that by the time a quote is transmitted to you, it is stale already, even if your trading server is collocated at the exchange. (Checking the time stamp of the quote is of no help: the time stamp is based on the time the quote enters the queue, not when it exits the queue.)
If you can no longer believe in the quotes, is there any integrity left in the market? Much as I think that HFT may be useful liquidity providers, I can't see how this specific practice could be good for anyone over the long term.
(Hat tip: Jim Liew of Alpha Quant Club.)
What are we to do with Sharpe ratio?
I wrote several times before how useless Sharpe ratio is for certain types of strategies: see here and here. Not only is a high Sharpe ratio quite useless in telling you what damage extreme events can do to your equity, a low Sharpe ratio is also quite useless in telling you what spectacular gain your strategy might enjoy in the event of a catastrophe. I came across another brilliant example of the latter category in the best-selling book "The Big Short", where the author tells of the story of the fund manager Mike Burry.
Mike Burry started buying credit default swaps in 2005, essentially an insurance policy on mortgage-backed securities, betting that there will be widespread defaults on mortgages. Of course, we now know how this story would turn out: Mike Burry made $750 million in 2007 alone. But there was nothing but pain for the fund manager and his investors in 2005-2006, since they had to pay an annual premium of 8% of the portfolio. Investors who measured the performance of this strategy using Sharpe ratio, without knowing the details of the strategy itself, would be quite justified to think that it was an utter disaster prior to 2007. And indeed, many of them lost no time in trying to pull out their investments.
So what are we to do with Sharpe ratio, with its inherent reliance on Gaussian distributions? Clearly, it is useful for measuring high frequency strategies which you can count on to generate consistent returns every day, but which has limited catastrophic risks. But it is less useful for measuring statistical arbitrage strategies that hold positions over multiple days, since there may well be substantial hidden catastrophic risks in these strategies that would not be revealed by their track record and standard deviation of returns alone. As for strategies that are designed to benefit from catastrophes, such as Mike Burry's CDS purchases or Nassim Taleb's options purchases, it is completely useless. If I were to allocate my assets over different hedge funds, I would be sure to include some funds in the first category to generate cash flows for my daily needs, as well as funds in the last category to benefit from the infrequent black-swan events. As for the funds in the middle category, I am increasingly losing my enthusiasm.
Mike Burry started buying credit default swaps in 2005, essentially an insurance policy on mortgage-backed securities, betting that there will be widespread defaults on mortgages. Of course, we now know how this story would turn out: Mike Burry made $750 million in 2007 alone. But there was nothing but pain for the fund manager and his investors in 2005-2006, since they had to pay an annual premium of 8% of the portfolio. Investors who measured the performance of this strategy using Sharpe ratio, without knowing the details of the strategy itself, would be quite justified to think that it was an utter disaster prior to 2007. And indeed, many of them lost no time in trying to pull out their investments.
So what are we to do with Sharpe ratio, with its inherent reliance on Gaussian distributions? Clearly, it is useful for measuring high frequency strategies which you can count on to generate consistent returns every day, but which has limited catastrophic risks. But it is less useful for measuring statistical arbitrage strategies that hold positions over multiple days, since there may well be substantial hidden catastrophic risks in these strategies that would not be revealed by their track record and standard deviation of returns alone. As for strategies that are designed to benefit from catastrophes, such as Mike Burry's CDS purchases or Nassim Taleb's options purchases, it is completely useless. If I were to allocate my assets over different hedge funds, I would be sure to include some funds in the first category to generate cash flows for my daily needs, as well as funds in the last category to benefit from the infrequent black-swan events. As for the funds in the middle category, I am increasingly losing my enthusiasm.
Pair trading technologies update
Pair trading was invented two decades ago, but automating its implementation has only recently become fashionable with independent traders. But once the spotlight is on, innovations come fast and furious. Here are a number of recent developments that I find interesting:
1. I mentioned previously the software called quant2ib. It is an API which allows us to get market data and send orders from a Matlab program to Interactive Brokers (IB). I have used it extensively for our trading, and it is as reliable as IB's native API. Their latest version now includes functions for constructing a "combo" security. This combo security can be pairs of stocks, ETF's, futures, etc. (with the notable exception of currencies), and the API allows you to get market data as well as to submit orders on a combo. This is a huge improvement because you can now automatically trade a pair of securities as one unit by submitting limit orders on the combo. (Previously, you would have had to submit market order on at least one side of the pair, and this would have required your program to continuously monitor the market prices and send orders when appropriate. Or else you had to give up using the API and manually enter a "generic combo" limit order in IB's TWS.)
2. Alphacet Discovery also has the ability to send limit orders on pairs, due to its partnership with Knight Trading. Besides, based on a demo that I have recently seen, they also now have great pairs portfolio and execution reporting functionality. (Full disclosure: I used to consult for them.)
3. IB itself has released a "Scale Trader" algorithm that can be applied to combos (see 1. above. Hat tip: Mohamed.) I can't explain this better than their press release: "... ScaleTrader algorithm allows clients to create conditions under which a long position in one stock is built while simultaneously creating an offsetting short position in the other. The ScaleTrader is named because investors can 'scale-in' to market weakness by setting orders to buy as the market moves lower. Similarly, sell orders can be 'scaled' into when a market is rising. The ScaleTrader algorithm can be programmed to buy the spread and subsequently take profit by selling the spread if the difference reaches predetermined levels set by the user." In other words, it allows us to automatically implement the "parameterless trading" or the "averaging-in" strategy that I blogged about previously without any programming on our part!
Speaking of pair trading, I will be teaching my first New York workshop in October. (My editor inevitably picks touristy locations for these workshops. My London workshop takes place across the street from the Tower of London, my New York workshop is across from the new World Trade Center, and my Hong Kong workshop is in the "Golden Mile" shopping district of Tsim Sha Tsui.)
1. I mentioned previously the software called quant2ib. It is an API which allows us to get market data and send orders from a Matlab program to Interactive Brokers (IB). I have used it extensively for our trading, and it is as reliable as IB's native API. Their latest version now includes functions for constructing a "combo" security. This combo security can be pairs of stocks, ETF's, futures, etc. (with the notable exception of currencies), and the API allows you to get market data as well as to submit orders on a combo. This is a huge improvement because you can now automatically trade a pair of securities as one unit by submitting limit orders on the combo. (Previously, you would have had to submit market order on at least one side of the pair, and this would have required your program to continuously monitor the market prices and send orders when appropriate. Or else you had to give up using the API and manually enter a "generic combo" limit order in IB's TWS.)
2. Alphacet Discovery also has the ability to send limit orders on pairs, due to its partnership with Knight Trading. Besides, based on a demo that I have recently seen, they also now have great pairs portfolio and execution reporting functionality. (Full disclosure: I used to consult for them.)
3. IB itself has released a "Scale Trader" algorithm that can be applied to combos (see 1. above. Hat tip: Mohamed.) I can't explain this better than their press release: "... ScaleTrader algorithm allows clients to create conditions under which a long position in one stock is built while simultaneously creating an offsetting short position in the other. The ScaleTrader is named because investors can 'scale-in' to market weakness by setting orders to buy as the market moves lower. Similarly, sell orders can be 'scaled' into when a market is rising. The ScaleTrader algorithm can be programmed to buy the spread and subsequently take profit by selling the spread if the difference reaches predetermined levels set by the user." In other words, it allows us to automatically implement the "parameterless trading" or the "averaging-in" strategy that I blogged about previously without any programming on our part!
Speaking of pair trading, I will be teaching my first New York workshop in October. (My editor inevitably picks touristy locations for these workshops. My London workshop takes place across the street from the Tower of London, my New York workshop is across from the new World Trade Center, and my Hong Kong workshop is in the "Golden Mile" shopping district of Tsim Sha Tsui.)
Subscribe to:
Comments (Atom)