What is Quant Trading and How Do I Learn It

Quantitative Trading

THE WHAT?

Quantitative trading refers to the process of trading i.e. purchase and sale of financial instruments, but using computers. But isn’t that what normal trading entails as well (at least after the advent of computers)?

Well, yes, but the main difference in this case is, these computers have to trade on their own i.e. they will mostly be on self help with minimal human intervention. The way this is achieved is through programs and algorithms which are developed by humans and these contain instructions for the computers to act upon later on without our help. Along with giving plain instructions, the computers are also taught to learn by themselves using Machine Learning.

And since, it’s mostly the computers who are making the calls, the decisions are devoid of any human emotions and it’s just a game of numbers and pure logic, hence the term Quantitative.

THE WHY?

The objective here is to take advantage of any persistent market opportunity that comes up or may come up and act at the earliest in order to make profit. And by acting, more often than not, it involves deciding whether to long (buy) or short (sell) a financial asset when its price is not what (we think) it should be.

Here’s how that would look when seen from the eyes of a computer –

If X happens, Y should happen.

If Y doesn’t happen, we do Z in anticipation that Y will happen.

To cite a practical example –

“If X happens (satellite images of Walmart stores shows an increase in the number of parked cars implying an increase in shoppers), Y should happen (the price of Walmart shares should rise)

If Y doesn’t happen (Walmart share price doesn’t go up), we do Z in anticipation of Y happening (buy Walmart share in anticipation that its price would go up, especially during the next quarterly earnings announcement)”

But why take the help of computers in the first place ?

Well, as humans and no matter how intelligent we are, we are inefficient when it comes to studying huge amounts of data of varying types, observing patterns in them and taking an action based on that in the “least possible time”; by being precise and purely logical at the same time. And hence, we take the help of computers.

For instance, it would be a nightmare if we were to observe all the satellite images ourselves to determine whether there is an increase in the number of shoppers at Walmart stores. We would have eventually done it but by taking five times more time than a computer along with tons of inaccuracies.

Thus, quantitative trading helps us with the following –

Analysing large amounts of data
Analysing data quickly
Analysing text or images (using machine learning)
Collecting large amounts of data (web scraping)
Executing a trade with lightning quick reactions
Executing many trades in a short time
Executing a trade where you need a precise price
Monitoring the markets 24/5 or 24/7

THE WHEN?

Quantitative Trading is a preferred mode of trading when there is an observable pattern in market opportunities i.e. when it keeps appearing repetitively in a manner similar to its previous appearance.

Manual Trading, on the other hand, is used in cases when the market opportunity is one-off i.e. there is no repetition.

SOME EXAMPLES

Quantitative Trading Strategy

If the price of Asset X changes, the price of Asset Y changes as well. Hence, Asset Y is bought or sold when any change is observed in the price of Asset X.
A trade is executed at a lightning speed using computers in reaction to any news but before the market in general can act on it.
The price of a group of stocks belonging to the same country and/or same sector usually change at the same time. On a particular day, one such stock behaves in an unusual fashion and that stock is bought or sold with the expectation that its price will revert back to comply with the other stocks in its group.

Manual Trading Strategy

When Hedge Fund Manager George Soros made a profit of $1 Billion by winning a bet that UK would be unable to maintain the value of British Pound beyond a certain point in 1992.
When the Winklevoss Twins rode the wave of Bitcoin to eventually become Billionaires due to them putting $11 Million in it in 2013. Incidentally, they were also the twins to sue Facebook CEO Mark Zuckerberg.
When one goes through the onerous task of sending someone to a Timber Processing factory on a daily basis to check the number of trucks leaving its premises; hence getting an idea about the factory’s supply and sales and putting a probable number on the company’s revenue.

THE MAKE UP

There are 3 domains in particular that have come together to give birth to Quantitative Trading, namely, Finance, Statistics and Programming.

FINANCE >> Rule of the Game

STATISTICS | PROGRAMMING >> Tools of the Game

Simply put, Finance happens to be the theoretical aspect while Statistics and Programming deal with the application side of the field.

FINANCE

Finance provides the knowledge and understanding that helps us to identify and judge which opportunity to act upon and which to let go. This is a prerequisite if one hopes to be successful in trading.

It also provides us a conceptual understanding as to how different asset classes work and what to do with them when it comes to executing a trade. For example, if we need to trade commodity futures, we need to have a clear understanding as to what futures are and how they work.

And not just Finance, having a sound knowledge of Economics helps as well. Because the underlying asset of any financial instrument is ultimately tied with the Economic scenario of any particular country or the world.

STATISTICS

Trading is a game of probability and in order to be adept at this game, Statistics is a field one cannot ignore.

One needs to understand the likelihood of something happening with a Financial Asset based on events and circumstances and then that likelihood needs to be quantified. This is where Statistics comes in as it provides various mathematical models and methods using which a certain element of certainty can be attached to the probabilistic nature of trading and multiple instances can be explored.

Statistics also plays a part in running simulations in Algo Trading wherein a particular market event is duplicated with different potential outcomes and based on that, the optimal betting size is chosen.

PROGRAMMING

This happens to be the last and definitely not the least amongst domains associated with Quantitative Trading. Once we have designed a trading strategy using the knowledge of Finance and Statistics, we need to communicate the same to the computer so that it can execute and test it, and this is where programming comes in.

The entire strategy is written using a particular programming language which are known as algorithms and any improvements or updates in the strategy are further incorporated in the same. This is a highly technical skill and programmers with specific knowledge are required to perform this process.

For instance, in order to evaluate comments and replies from web forums of a restaurant review site and develop a pattern, one needs to write a program to perform Data Scraping.

ONE PERSON GAME?

Can an individual run a Quantitative Trading Strategy? Definitely, partially thanks to the times we live in. With easy access to powerful computers, softwares and data at an economical price, an individual can design and run a quantitative trading strategy. However, there is a caveat when it comes to High Frequency Trading or HFT.

HFT is a type of Quantitative Trade that is difficult for a single person to undertake. Mostly because it involves high computing and communication speeds which makes it very expensive and also requires the expertise of highly educated and skilled professionals like Computer and Data Scientists.

Furthermore, though an individual can execute a Quantitative Trade, that doesn’t ensure that he/she can remain profitable in the long term. Why is it so? Well, simply because playing football in one’s backyard and playing for the national team entails a different level of expertise and persistence. Though the tools and rules of the game remain the same, the long term achievements can vary drastically.

THE SUCCESS

How to become a successful quantitative trader? Well, if you want to play for the nationals i.e. be a player in the A Game, the obvious but not so easy answer would be to build your foundation first; which includes getting a very good educational degree, probably a Masters or a PHD in Statistics, Engineering, Computational Finance, etc.

Now, unless you have a ton of money and want to join a firm that your parents do not own, that degree would open the pathway for you to join a major trading firm and this can then become a fast and prudent way for you to get the necessary exposure to become a successful trader.

This is not to say that the degree is just a pathway to join a top firm but it helps to have proper theoretical knowledge before jumping into the actual world of trading.

In a top trading firm, you will be exposed to the requisite knowledge, connections and mentorship that will in turn help build your credibility and consequential success in this field.

But fortunately there is also an alternative other than getting formal education and targeting top tier trading firms.

Here are the steps –

Find a mentor/be an apprentice
Work backwards from the job descriptions
Contact those not in the HR department
Get hired at a lower tier firm (first)
Get your foot through the door in a related role
Get good at trading

When you are going by the above route however, there is a lot of self learning that is involved followed by a lot of trial and error in the strategies that you need to design, execute and test yourselves. The process entails a lot of patience and perseverance, which if stuck out, can ultimately help you to become a successful trader.

SOME RESOURCES

Recommended Books

Evaluation and Optimization of Trading Strategies – Pardo (Good insights on basic quantitative methods on building and testing trading strategies)

Trade your way to Financial Freedom – Van K Tharp (Ridiculous-Click bait title aside, this book is a great overview to mechanical trading systems)

Quantitative Trading – Ernest Chan (Introduction to basic quantitative trading on a retail level)

Trading and Exchanges: Market Microstructure for Practitioners – Larry Harris (Market microstructure is the science of how financial exchanges and systems function and what actually happens when a trade is placed)

The Most Important Thing – Howard Marks. Mr Marks is managing over 100 billion USD in his fund, Oaktree Capital (This is not a quantitative trading book but it provides some good mental models about the markets)

The Quants – Scott Patterson (War stories of some top quants. Good as a bedtime read. P.S. This book started me on the path of quantitative trading. Previously, I was a Buffett value investing guy)

Recommended Readings

Edward Thorp Articles (Edward Thorp one of the pioneers of Quantitative Finance/Trading, I suggest reading up on all his works)

Statistical Arbitrage – An interview with Edward Thorp (Statistical Arbitrage is one of the first quantitative strategies. It started in the 1970s)

4 Algorithmic Trading Strategies that Work Today

How Can Retail Traders Beat Institutional Traders and Hedge Funds?

Futures Trading Strategies Made Simple – A Complete Guide

Sentiment Analysis with Python (Finance) – A Beginner’s Guide

Algo Trading A.I.