Guide to algorithmic trading and quant funds’ profitability

In this article we will take a closer look at what algorithmic trading is and what are different types of trading strategies. Will also check the performance of chosen hedge funds that use quantitive approach to investing. Let’s first see our introductory movie…

Algorithmic Trading (also called quantitative or automated trading) in simple words describes the process of using computer programs to automate the process of trading (buying and selling) financial instruments (stocks, currencies, cryptocurrencies, derivatives). These computer programs are coded to trade based on the input that has been defined for them. Inputs could be based on the aimed strategy to take advantage of different market behaviors such as the specific change of a price could trigger the algorithms to make some specific trades, or other factors like volume, time or sophisticated algorithms that trade based on trading indicators.

Almost all trading ideas are first converted to a trading strategy and coded into an algorithm that then comes to life and is ready for execution. Most algorithmic trading strategies are created on the basis of wide trading knowledge of the financial market combined with quantitative analysis and mathematical modeling. Later the strategies are given to quants programmers who convert the strategy to executable algorithms.

It is widely common to perform testing on trading strategies before they go live on the market, this practice is known as Backtesting. This is where the algorithm is tested on historical data to check the algorithm and apply further modifications.

The main goal of backtesting is to evaluate the performance of the algorithmic strategy. The strategy is tested if it behaves as it was assumed in real market situations.  And its profitability is checked using historical market data.

For more sophisticated algorithms and firms with more advanced tools, algorithmic strategies perform on what so-called paper trading, where the strategy performs virtual trading without committing any commercial value (trading without money).

The most popular programming languages used to write automated trading strategies are JAVA, Python, and C++. Matlab is also a good tool with a wide range of analytic tools to plot and analyze algorithmic strategies.

By far the most common fans of performing trades algorithmically are larger financial institutions as well as investment banks alongside Hedge Funds, pension funds, broker-dealers, and market makers.

Some well-known algorithmic strategies

On a broad sense most commonly used algorithmic strategies are Momentum strategies, as the names indicate the algorithm starts execution based on a given spike or given moment. The algorithm basically detects the moment (e.g spike) and executed by and sell order as to how it has been programmed.

One another popular strategy is the mean-reversion algorithmic strategy. This algorithm assumes that prices usually deviate back to their average.

A more sophisticated type of algo trading is a market-making strategy, these algorithms are known as liquidity providers. Market making strategies aim to supply buy and sell orders in order to fill the order book and make a certain instrument in a market more liquid. Market making strategies are designed to capture the spread between buying and selling prices and ultimately decrease the spread.

Another advanced and complex algorithmic strategy is arbitrage algorithms. These algorithms are designed to detect mispricing and spread inefficiencies among different markets. Basically, Arbitrage algorithms find the different prices among two different markets and buy or sell orders to take advantage of the price difference.

Among big investment banks and hedge funds trading with high frequency is also a popular practice. A great deal of all trades executed globally is done with high-frequency trading. The main aim of high-frequency trading is to perform trades based on market behaviors as fast and as scalable as possible. Though, high-frequency trading requires solid and somewhat expensive infrastructure. Firms that would like to perform trading with high frequency need to collocate their servers that run the algorithm near the market they are executing to minimize the latency as much as possible.

Adaptive Implementation Shortfall algorithm designed for reduction of market impact during executing large orders. It allows keeping trading plans with automatic reactions to price liquidity.

Basket Orders is a strategy designed to automate the parallel trading of many assets, balancing their share in the portfolio’s value.

Bollinger Band

Bollinger bands strategy is a trading algorithm that computes three bands – lower, middle, and upper. When the middle band crosses one of the other from the proper side then some order is made.

CCI

The commodity channel index strategy is a trading algorithm whose actions are dependent on the value of a CCI index which bases on the average and variance of some number of last trades.

MACD

MACD strategy is a trading algorithm whose actions are dependent on two lines of MACD and the MACD Signal Line calculated with EMA.

Market Close

The strategy is designed to reduce costs interrelated with the market impact of huge orders. It works until the demanded time and may take advantage of the auction on Market Close.

Parabolic SAR

Parabolic SAR strategy is a trading algorithm whose role is to predict market trend change and trade assets in specific market conditions.

POV

Percent of Volume (POV) is a trading algorithm based on volume used for the execution of bigger orders without excessive impact on the market price.

RSI

Relative strength index strategy is the trading algorithm whose actions are dependent on the value of an RSI index which bases on the average wins and losses of a strategy.

Slow Stochastic Oscillator

The Slow Stochastic Oscillator Strategy is built to gain profit by buying/selling shares in specific market conditions.

Statistical Arbitrage

Statistical Arbitrage (SA) is built to gain profit by simultaneously buying and selling two shares of two correlated instruments.

TWAP

Time-Weighted Average Price (TWAP) is a trading algorithm based on the weighted average price used for the execution of bigger orders without excessive impact on the market price.

VWAP

Volume-Weighted Average Price (VWAP) is a trading algorithm based on a pre-computed schedule that is used in the execution of a bigger order without an excessive impact on the market price.

Williams %R

Williams %R strategy is a trading algorithm based on trend change indicated by the Williams %R oscillator. The oscillator leads the strategy to set a long or short position.

Smart Order Routing

Technically Smart Order Routing technology will search for available liquidy across given trading venues, and with mid-point matching will get the best possible chance of price improvements.

Triangular Arbitrage

Triangular Arbitrage is used when a trader would like to use the opportunity of exploiting the arbitrage opportunity from three different FX currencies or Cryptocurrencies. Triangular Arbitrage happens when there are different rates within the trading venue/s.

Based on the given use case like the size of orders, customizability, and experience level there are options available for algo trading software. Larger firms like hedge funds, investment banks, or proprietary trading firms use rather more tailored custom-built and advanced tools. When it comes to more individual traders or quants with less capital to trade they will rather use more readymade algorithmic strategies, some on the cloud, some stand-alone.

The most common features of algorithmic trading software are ways to analyze the profit/loss of an algorithm on live market data. There are different protocols available to get, process and send orders from software to market, such as TCP/IP, webhooks, FIX and etc. One important factor for this data processing from receiving to processing and pushing order is measured latency. Latency is the time delay introduced to the movement of data from point to point. Considering the changes in price in the market the lower obtained latency the better software reacts to market events hence a faster reaction.

Backtesting is another useful feature that should be included in algo trading software, usually, this software allows traders to apply their automated trading strategies and test it with historical data to evaluate the profitability of their strategies.

Pros and cons of algorithmic trading

Just like any other choice, there are pros and cons to using algorithmic trading strategies and automating the process of trading. Let’s get down with the pros. Based on many expert opinions on investments human emotions could be toxic and faulty when it comes to trading, one perhaps most acknowledged pros of quantitative Trading is taking away human emotions and errors of trading.

Another huge advantage of algorithmic trading is the increase of speed in the action of execution to the market as well as the possibility to test strategies using Backtesting and paper-trading in a simulated manner. Testing quantitative strategies determine the viability of the idea behind trading strategies.

Another vastly discussed advantage of quantitative trading is risk diversification. Algorithmic trading allows traders to diversify themselves across many accounts, strategies, or markets at any given time. The act of diversification will spread the risk of different market instruments and hedge them against their losing positions.

Making trading automatically using quant trading decreases the operational costs of performing large volumes of trade in a short period of time.

There are also a few other advantages such as automation in the allocation of assets, keeping a consistent discipline in trading, and faster execution.

Now let’s get on with some of the cons of using algorithmic trading. Perhaps one very discussed issue with using algorithmic trading is constant monitoring of the strategies which to some traders could be a bit stressful since the human control in automated trading is much less. Though it is widely common to have lost control features included in strategies and algorithmic trading software (automated and manual ones).

For most individual traders having enough resources could be another disadvantage of Algorithmic trading. Automated trading reduces the cost of executing large orders but it could come expensive as it requires initial infrastructure such as the software cost or the server cost.

 Pros Cons Emotionless trading Needs for monitoring Less error Technological infrastructure Higher trading speed Programming skills required for updating strategies Backtesting and paper trading Risk diversification Lower operational costs Consistent trading discipline

Performance of quant funds

There are different performance results depending on the basis on which an algorithmic trading strategy is built. Though, as an example, an algorithmically managed fund in 2018 (during which the S&P500 index was 19.42% high) SH capital partners posted 234.09% returns. Over the same period, Silver8 Partners and Global Advisors Bitcoin Investment Fund achieved 770.75% and 330.08% returns respectively.  Both of these algorithmic trading examples are automatically traded but differ on specific strategies – however, both attribute their success to their Automatic trading winning strategies and their rationale on digital assets.

Even most profitable algorithms with reasonable levels of volatility (eg. a Sharpe ratio of 2+ and max drawdowns of <5–10%) have a limited shelf life because any Algo that produces consistent greater-than-market returns will suffer from alpha decay (the erosion of edge due to others getting in on the action).

In order to provide a better view of performance statistics, we have prepared results from the Reinsseance hedge fund, see the table below:

The are some performance statistics from the Reinsurance trading firm:

 Year Net return Management fee Performance fee Returns before fees Size of the fund Medallion trading profits 1988 9.0% 5% 20% 16.3% \$20 million \$3 million 1989 -0.4% 5% 20% 1.0% \$20 million \$0 1990 55.0% 5% 20% 77.8% \$30 million \$23 million 1991 39.4% 5% 20% 54% \$42 million \$23 1992 33.6% 5% 20% 47% \$74 million \$35 million 1993 39.1% 5% 20% 53.9% \$122 million \$66 million 1994 70.7% 5% 20% 93.4% \$276 million \$258 million 1995 38.3% 5% 20% 52.9% \$462 million \$244 million 1996 31.5% 5% 20% 44.4% \$637 million \$283 million 1997 21.2% 5% 20% 31.5% \$829 million \$261 million 1998 41.7% 5% 20% 57.1% \$1.1 billion \$261 million 1999 24.5% 5% 20% 35.6% \$1.54 billion \$549 million 2000 98.5% 5% 20% 128.1% \$1.9 billion 2,434 million 2001 33.0% 5% 36% 56.6% \$3.8 billion 2,149 million 2002 25.8% 5% 44% 51.1% \$5.24 billion 2.676 billion 2003 21.9% 5% 44% 44.1% \$5.09 billion \$2.245 billion 2004 24.9% 5% 44% 49.5% \$5.2 billion \$2.572 billion 2005 29.5% 5% 44% 57.7% %5.2 billion \$2.572 billion 2006 44.3% 5% 44% 84.1% \$5.5 billion \$4.374 billion 2007 73.7% 5% 44% 136.6 \$5.2 billion \$7.104 billion 2008 82.4% 5% 44% 152.1% \$5.2 billion \$7.911 billion 2009 39.0% 5% 44% 74.6% \$5.2 billion \$3.881 billion 2010 29.4% 5% 44% 57.7% \$5.2 billion \$3.881 billion 2011 37.0% 5% 44% 71.1% \$10 billion \$7.107 billion 2012 29.0% 5% 44% 56.8% \$10 billion \$5.679 billion 2013 46.9% 5% 44% 88.8% \$10 billion \$8..875 billion 2014 39.2% 5% 44% 75.0% \$9.5 billion 7.125 billion 2015 36.0% 5% 44% 69.3% \$9.5 billion \$6.582 billion 2016 35.6% 5% 44% 68.6% \$9.5 billion \$6.514 billion 2017 45.0% 5% 44% 85.4% \$10 billion \$8.536 billion 2018 40.0% 5% 44% 76.4% \$10 billion 7.643 billion

Source: The man who solved the market, how Jim Simons launched the quant revolution, by Gregory Zuckerman

The Reinsurance hedge fund in total achieved 39.1% net returns, 66.1% average returns before fees and in total \$104,530,000,000 total trading profits.

Unlike more mature instruments like stocks, options, or CFDs, the Cryptocurrency market is quite volatile. Typically higher volatility leads to more frequent jumps in the price of instruments, higher and lower. Hence, some professional traders find this amusing and opportunistic to make the most of the profits.

Generally, for Cryptocurrency traders, there are plenty of cloud-based solutions using trading bots, though for very professional and institutional traders this may not flexible enough. There are few automated trading platforms for cryptocurrencies that can utilize the need for more sophisticated and institutional traders.

On average 80% of the daily traders across the US are done by algorithmic trading and machines. Though the volume of automated trading can change based on the volatility in the market. According to J.P. Morgan, fundamental discretionary traders are accounted for only 10% of trading volume in stocks. This is the traditional way of checking the companies’ business performance and outlook before deciding whether to buy or sell a position.

The growth in the number of algorithmic trading since last year comes close to 47% and there is 41% growth in the number of users executing their trades algorithmically. Mobile also plays an important role in the tools provided there is around 54% growth in trading FX algorithmically using mobile devices.

New technologies, Artificial Intelligence, Machine Learning, Blockchain

According to another J.P. Morgan research, Artificial Intelligence and Machine learning are predicted to be the most influential in shaping the future of trading. Based on this analysis Artificial Intelligence and Machine Learning will influence the future of trading by 57% and 61% in the next three years.

Interestingly this report states that Natural Language Processing alone will count for 5% of the change in the next 12 months and up to 9% in the next three years.

J.P. Morgan’s report shows that around 68% of traders believe that Artificial Intelligence and Machine Learning provide deep data analytics. Around 62% believe that Artificial Intelligence and Machine Learning optimize trade execution and 49% of traders believe that Artificial Intelligence and Machine Learning represent an opportunity to hone their trading decisions.

The same report indicates that Blockchain within the next 12 months will influence trading up to 9% and 19% within the next three years. Within the same report, the usage of mobile trading applications is to influence the trading market by up to 28% within the next 12 months and 11% within the next 3 years.

Market share

Morgan Stanley estimated in 2017 that algorithmic strategies have grown at 15% per year over the past six years and control about \$1.5 trillion between hedge funds, mutual funds, and smart beta ETFs. Other reports suggest the quantitative hedge fund industry was about to exceed \$1 trillion AUM, nearly doubling its size since 2010 amid outflows from traditional hedge funds. In contrast, total hedge fund industry capital hit \$3.21 trillion according to the latest global Hedge Fund Research report.