In this overview, we will get to know the concept of quantitative trading. We will look at what it is for and its advantages and disadvantages.
What is quantitative trading?
Quantitative trading is a set of trading strategies based on quantitative analysis, which uses mathematical calculations and statistical calculations to identify trading opportunities. The price of a financial instrument and its volume of trades are among the most common parameters of mathematical models used in quantitative analysis and trading.
Quantitative trading involves trading strategies and decisions based on historical data, statistical indicators and hypotheses about future events and their impact on financial markets. Simply put, the essence of quantitative trading is the use of an effective trading strategy, created on the basis of analysis of a wide variety of information.
Today, quantitative strategies are mainly used by institutional investors and various hedge funds. Such trading is characterised by high volumes and a large number of trading transactions. Modern technology, professional equipment and all available data on the financial instrument are used.
Fundamentals of quantitative trading
The quantitative trading system has four main components:
- Strategy selection. All quantitative trading processes start with an initial research period. This research process includes finding a suitable strategy, obtaining the data needed to test the strategy, and a preliminary assessment of its effectiveness. The chosen strategy is then subjected to serious analysis and refinement in order to increase the potential profitability and at the same time reduce the risks associated with trading.
- Testing the strategy on history. Once the strategy is defined, it is necessary to test on historical data and possibly optimise some parameters. Although historical testing does not fully guarantee that a strategy will be successful in real time, it is a certain test of a strategy's quality and viability. Standard indicators to assess the effectiveness of quantitative strategies are maximum drawdown and Sharpe ratio.
- Execution system. The execution system is the means by which the list of trades generated by a strategy is executed by the broker. While trade generation can be semi-automated or even fully automated, the execution mechanism can be manual, semi-manual, or fully automated. The key features of the execution system are: a professional trading interface, automation and high speed of transactions, and minimisation of costs (including commission, slippage and spread).
- Risk management. Quantitative trade risk management is designed to take into account all possible risks or events that could interfere with trading. It includes not only trading risks, but also technological risks (server failure) and broker risks (broker's bankruptcy). The optimal capital allocation - a set of rules, according to which the capital is allocated in certain proportions to different strategies and deals within the framework of these strategies - also plays an important role here.
Quantitative trading strategies
Let's look at a few popular areas of quantitative trading:
● Use of alternative data. Typically, mathematical models use price or volume data. Alternative data includes non-traditional data, which also has predictive value in financial markets. Such data could include, for example: weather forecasts, satellite imagery, social media information and others.
● Little-known markets. Little-known markets are less popular and less regulated, but can still provide good trading opportunities. Finding and exploiting market imbalances in such markets is one area for quantitative trading.
● High frequency trading (HFT). The main characteristics that distinguish high-frequency trading are the high execution speed, the large number of trades and the short holding time. Many arbitrage strategies are based on this. High frequency trading requires a high degree of automation, a professional software interface and high quality high-speed communications.
● Artificial Intelligence. Using artificial intelligence is a form of trading in which a computer gradually learns from historical and current data. It learns from historical experience to the point where eventually it no longer needs to be told what actions to take. Once it reaches a certain level, the AI can make and execute trading decisions on its own.
Advantages and disadvantages of quantitative trading
The benefits of quantitative trading:
● Quantitative trading helps you make promising trading decisions by providing a multi-faceted analysis of the factors affecting trading.
● Can find market imbalances and exploit them for profit.
● Promotes rational decision-making by screening out fear, greed and other negative emotions.
● Quantitative trading methods improve trading efficiency by using mathematics and computer algorithms, eliminating or minimising human error.
The disadvantages of quantitative trading:
● Algorithmic models must be regularly adapted and changed due to volatile financial market conditions. As market conditions change, trading algorithms need to be reviewed and optimised.
● Highly labour-intensive process. High intellectual, financial and technical costs are required.
● Qualitative analysis requires access to a huge amount of different data.
Conclusion
Quantitative trading is a trading strategy based on the complex use of sophisticated mathematical and statistical models. It uses historical data and special algorithms to calculate optimal trading strategies. Due to high capital requirements, equipment and automation of trading processes, quantitative trading is mainly used by institutional investors.
By Andrey Goilov, analyst at RoboForex.