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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.)
The Quants
Once in a while, a book about trading written for the general public contains some useful nuggets even for professionals. Fortune's Formula was one. It introduced me to the world of Kelly's formula, Universal Portfolios, and the maximization of compounded growth rate. The Quants, by WSJ reporter Scott Patterson, is another. (Hat tip to my partner Steve for telling me about it.)
What is the most important take-away in The Quants? No, it is not that you should learn to become a master poker player or chess player before hoping to make it big, though you would think that given Patterson's exhaustive coverage of poker games played by the top quants. Among my own professional acquaintances, trader-poker-players are still a minority.
The most important take-away is what ex-employees said about Renaissance Technologies: "there is no secret formula for the fund's success, no magic code discovered decades ago by geniuses .... Rather, Madallion [Fund]'s team of ninety or so Ph.D.'s are constantly working to improve the fund's systems, ..."
In other words, though you may not have 90 Ph.D.'s at your disposal, you can still work on continuously improving/refining your strategies, improving the engineering of your trading environment, and increasing the diversity of your strategies. And though you may still not archive 60-70% annualized returns every year, you will nevertheless enjoy stable returns year after year.
By the way, it is good to see my ex-colleagues Lalit Bahl, Vincent and Stephen Della Pietra mentioned in the book, all of whom left IBM to join Renaissance many years ago, and who are extraordinarily nice and friendly guys, quite in contrast to the norm on Wall Street.
What is the most important take-away in The Quants? No, it is not that you should learn to become a master poker player or chess player before hoping to make it big, though you would think that given Patterson's exhaustive coverage of poker games played by the top quants. Among my own professional acquaintances, trader-poker-players are still a minority.
The most important take-away is what ex-employees said about Renaissance Technologies: "there is no secret formula for the fund's success, no magic code discovered decades ago by geniuses .... Rather, Madallion [Fund]'s team of ninety or so Ph.D.'s are constantly working to improve the fund's systems, ..."
In other words, though you may not have 90 Ph.D.'s at your disposal, you can still work on continuously improving/refining your strategies, improving the engineering of your trading environment, and increasing the diversity of your strategies. And though you may still not archive 60-70% annualized returns every year, you will nevertheless enjoy stable returns year after year.
By the way, it is good to see my ex-colleagues Lalit Bahl, Vincent and Stephen Della Pietra mentioned in the book, all of whom left IBM to join Renaissance many years ago, and who are extraordinarily nice and friendly guys, quite in contrast to the norm on Wall Street.
A HFT primer
As a follow-up of my previous discussions on high frequency trading, I have invited guest blogger Jennifer Groton to share with us a quick survey of various common HFT strategies used by equities and FX traders.
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High frequency trading strategies are under fire. The recent trading spike in our national exchanges was duly noted as a short-circuit waiting to happen and drew immediate industry criticism of auto-trading robots. Before a witch-hunt ensues, perhaps a review of the common HFT strategies in stocks and Forex is in order.
High-frequency firms employ a wide variety of low-margin trading strategies that are implemented by professional market intermediaries who have invested heavily in technology. These firms claim that they make markets more efficient by enhancing liquidity and transparent price discovery to the benefit of investors. The Forex market’s unique combination of high liquidity and low volatility make it an ideal environment for deploying HFT strategies, although many of the ideas and technology are from the equity markets. The basic strategies fall into three categories: market-making, trending or predictive, and classic arbitrage.
Market-making strategies tend to focus on a single stock or currency pair. Many firms in this area have been described as engaging in "rebate-capture trading", a reference to the credits that firms get for providing liquidity on most market centers.
The second group consists of mean-reversion and trending strategies. These utilize technical indicators for stocks or forex indicators for currencies, and seek to generate more return from individual trades.
The last group may involve a cross-section of trades from multiple markets. The classic arbitrage strategy is a form of the “carry trade” that uses the prices of a domestic bond, a bond denominated in a foreign currency, the spot price of the currency, and the price of a forward contract on the currency. If the market prices are sufficiently different from those implied in the model to cover transactions costs, then four transactions can be made to guarantee a risk-free profit.
High frequency trading is attributed with generating over 70% of the volume of trades on our equity markets. Similar statistics are not available for forex markets, but speculating disguised as commercially necessary trades have been reported to be over two-thirds of the volume. Liquidity and pricing transparency are the benefits offered by its advocates, but regulators and other market participants who disagree with this positive assessment are presently discounting these benefits. Transaction taxes and time limits on orders have been proposed to mitigate the perceived risk created by HFT firms, but the wheels of Washington move slowly, even in crisis. For the time being, there is no indication that their participation will be discontinued.
==
High frequency trading strategies are under fire. The recent trading spike in our national exchanges was duly noted as a short-circuit waiting to happen and drew immediate industry criticism of auto-trading robots. Before a witch-hunt ensues, perhaps a review of the common HFT strategies in stocks and Forex is in order.
High-frequency firms employ a wide variety of low-margin trading strategies that are implemented by professional market intermediaries who have invested heavily in technology. These firms claim that they make markets more efficient by enhancing liquidity and transparent price discovery to the benefit of investors. The Forex market’s unique combination of high liquidity and low volatility make it an ideal environment for deploying HFT strategies, although many of the ideas and technology are from the equity markets. The basic strategies fall into three categories: market-making, trending or predictive, and classic arbitrage.
Market-making strategies tend to focus on a single stock or currency pair. Many firms in this area have been described as engaging in "rebate-capture trading", a reference to the credits that firms get for providing liquidity on most market centers.
The second group consists of mean-reversion and trending strategies. These utilize technical indicators for stocks or forex indicators for currencies, and seek to generate more return from individual trades.
The last group may involve a cross-section of trades from multiple markets. The classic arbitrage strategy is a form of the “carry trade” that uses the prices of a domestic bond, a bond denominated in a foreign currency, the spot price of the currency, and the price of a forward contract on the currency. If the market prices are sufficiently different from those implied in the model to cover transactions costs, then four transactions can be made to guarantee a risk-free profit.
High frequency trading is attributed with generating over 70% of the volume of trades on our equity markets. Similar statistics are not available for forex markets, but speculating disguised as commercially necessary trades have been reported to be over two-thirds of the volume. Liquidity and pricing transparency are the benefits offered by its advocates, but regulators and other market participants who disagree with this positive assessment are presently discounting these benefits. Transaction taxes and time limits on orders have been proposed to mitigate the perceived risk created by HFT firms, but the wheels of Washington move slowly, even in crisis. For the time being, there is no indication that their participation will be discontinued.
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