How to Choose the Right Quantitative Trading Strategy for Your Style

Right Quantitative Trading Strategy for Your Style

Whether a strategy is viable often does not have anything to do with the strategy itself it has to do with you. Here are some considerations.

Your Working Hours

Do you trade only part time? If so, you would probably want to consider only strategies that hold overnight and not the intraday strategies. Otherwise, you may have to fully automate your strategies so that they can run on autopilot most of the time and alert you only when problems occur.

When I was working full time for others and trading part time for myself, I traded a simple strategy in my personal account that required entering or adjusting limit orders on a few exchange-traded funds (ETFs) once a day, before the market opened. Then, when I first became independent, my level of automation was still relatively low, so I considered only strategies that require entering orders once before the market opens and once before the close. Later on, I added a program that can automatically scan real-time market data and transmit orders to my brokerage account throughout the trading day when certain conditions are met. So trading remains a “part-time” pursuit for me, which is partly why I want to trade quantitatively in the first place.

Your Programming Skills

Are you good at programming? If you know some programming languages such as Visual Basic or even Java, C#, or C++, you can explore high-frequency strategies, and you can also trade a large number of securities. Otherwise, settle for strategies that trade only once a day, or trade just a few stocks, futures, or currencies. (This constraint may be overcome if you don’t mind the expense of hiring a software contractor.)

Your Trading Capital

Do you have a lot of capital for trading as well as expenditure on infrastructure and operation? In general, I would not recommend quantitative trading for an account with less than $50,000 capital. Let’s say the dividing line between a high- versus low-capital account is $100,000. Capital availability affects many choices; the first is whether you should open a retail brokerage account or a proprietary trading account. For now, I will consider this constraint with strategy choices in mind.

With a low-capital account, we need to find strategies that can utilize the maximum leverage available. (Of course, getting a higher leverage is beneficial only if you have a consistently profitable strategy.) Trading futures, currencies, and options can offer you higher leverage than stocks; intraday positions allow a Regulation T leverage of 4, while interday (overnight) positions allow only a leverage of 2, requiring double the amount of capital for a portfolio of the same size. Finally, capital (or leverage) availability determines whether you should focus on directional trades (long or short only) or dollar-neutral trades (hedged or pair trades). A dollarneutral portfolio (meaning the market value of the long positions equals the market value of the short positions) or market-neutral portfolio (meaning the beta of the portfolio with respect to a market index is close to zero, where beta measures the ratio between the expected returns of the portfolio and the expected returns of the market index) require twice the capital or leverage of a long- or short-only portfolio. So even though a hedged position is less risky than an unhedged position, the returns generated are correspondingly smaller and may not meet your personal requirements.

Capital availability also imposes a number of indirect constraints. It affects how much you can spend on various infrastructure, data, and software. For example, if you have low trading capital, your online brokerage will not be likely to supply you with real-time market data for too many stocks, so you can’t really have a strategy that requires real-time market data over a large universe of stocks. (You can, of course, subscribe to a third-party market data vendor, but then the extra cost may not be justifiable if your trading capital is low.) Similarly, clean historical stock data with high frequency costs more than historical daily stock data, so a high frequency stock-trading strategy may not be feasible with small capital expenditure. For historical stock data, there is another quality that may be even more important than their frequencies: whether the data are free of survivorship bias. I will define survivorship bias in the following section. Here, we just need to know that historical stock data without survivorship bias are much more expensive than those that have such a bias. Yet if your data have survivorship bias, the backtest result can be unreliable.

The same consideration applies to news whether you can afford a high coverage, real-time news source such as Bloomberg determines whether a news driven strategy is a viable one. Same for fundamental (i.e., companies’ financial) data whether you can afford a good historical database with fundamental data on companies determines whether you can build a strategy that relies on such data.

Table.1 lists how capital (whether for trading or expenditure) constraint can influence your many choices.

This table is, of course, not a set of hard-and-fast rules, just some issues to consider. For example, if you have low capital but opened an account at a proprietary trading firm, then you will be free of many of the considerations above (though not expenditure on infrastructure). I started my life as an independent quantitative trader with $100,000 at a retail brokerage account (I chose Interactive Brokers), and I traded only directional, intraday stock strategies at first. But when I developed a strategy that sometimes requires much more leverage in order to be profitable, I signed up as a member of a proprietary trading firm as well. (Yes, you can have both, or more, accounts simultaneously. In fact, there are good reasons to do so if only for the sake of comparing their execution speeds and access to liquidity. See “Choosing a Brokerage or Proprietary Trading Firm”.)

Despite my frequent admonitions here and elsewhere to beware of historical data with survivorship bias, when I first started I downloaded only the split-and-dividend-adjusted Yahoo! Finance data.

How Capital Availability Affects Your Many Choices?

using the download program from HQuotes.com (The different databases and tools). This database is not survivorship bias free but more than two years later, I am still using it for most of my backtesting! In fact, a trader I know, who each day trades more than 10 times my account size, typically uses such biased data for his backtesting, and yet his strategies are still profitable. How can this be possible? Probably because these are intraday strategies. It seems that the only people I know who are willing and able to afford survivorship bias free data are those who work in money management firms trading tens of millions of dollars or more (that includes my former self). So, you see, as long as you are aware of the limitations of your tools and data, you can cut many corners and still succeed.

Though futures afford you high leverage, some futures contracts have such a large size that it would still be impossible for a small account to trade. For instance, though the platinum future contract on the New York Mercantile Exchange (NYMEX) has a margin requirement of only $8,100, its nominal value is currently about $100,000. Furthermore, its volatility is such that a 6 percent daily move is not too rare, which translates to a $6,000 daily profit-and-loss (P&L) swing in your account due to just this one contract. (Believe me, I used to have a few of these contracts in my account, and it is a sickening feeling when they move against you.) In contrast, ES, the E-mini S&P 500 future on the Chicago Mercantile Exchange (CME, soon to be merged with NYMEX), has a nominal value of about $67,500, and a 6 percent or larger daily move happened only twice in the last 15 years. That’s why its margin requirement is $4,500, only 55 percent that of the platinum contract.

Your Goal

Most people who choose to become traders want to earn a steady (hopefully increasing) monthly, or at least quarterly, income. But you may be independently wealthy, and long-term capital gain is all that matters to you. The strategies to pursue for short-term income versus long-term capital gain are distinguished mainly by their holding periods. Obviously, if you hold a stock for an average of one year, you won’t be generating much monthly income (unless you started trading a while ago and have launched a new subportfolio every month, which you proceed to hold for a year that is, you stagger your portfolios.) More subtly, even if your strategy holds a stock only for a month on average, your month-to-month profit fluctuation is likely to be fairly large (unless you hold hundreds of different stocks in your portfolio, which can be a result of staggering your portfolios), and therefore you cannot count on generating income on a monthly basis. This relationship between holding period (or, conversely, the trading frequency) and consistency of returns (that is, the Sharpe ratio or, conversely, the drawdown) will be discussed further in the following section. The upshot here is that the more regularly you want to realize profits and generate income, the shorter your holding period should be.

There is a misconception aired by some investment advisers, though, that if your goal is to achieve maximum long-term capital growth, then the best strategy is a buy-and-hold one. This notion has been shown to be mathematically false. In reality, maximum long-term growth is achieved by finding a strategy with the maximum Sharpe ratio (defined in the next section), provided that you have access to sufficiently high leverage. Therefore, comparing a short-term strategy with a very short holding period, small annual return, but very high Sharpe ratio, to a long-term strategy with a long holding period, high annual return, but lower Sharpe ratio, it is still preferable to choose the short-term strategy even if your goal is long-term growth, barring tax considerations and the limitation on your margin borrowing (money and risk management).