Algorithmic Trading Winning Strategies and their Rationale

This book is a practical guide to algorithmic trading strategies that can be readily implemented by both retail and institutional traders. It is not an academic treatise on fi nancial theory. Rather, I hope to make accessible to the reader some of the most useful fi nancial research done in the past few decades, mixing them with insights I gained from actually exploiting some of those theories in live trading. Because strategies take a central place in this book, we will cover a wide array of them, broadly divided into the mean-reverting and momentum camps, and we will lay out standard techniques for trading each category of strategies, and equally important, the fundamental reasons why a strategy should work. The emphasis throughout is on simple and linear strategies, as an antidote to the overfi tting and data-snooping biases that often plague complex strategies.

We will explain the simplest techniques and strategies for trading meanreverting portfolios (linear, Bollinger band, Kalman fi lter), and whether using raw prices, log prices, or ratios make the most sense as inputs to these tests and strategies. In particular, we show that the Kalman fi lter is useful to traders in multiple ways and in multiple strategies. Distinction between time series versus cross-sectional mean reversion will be made. We will debate the pros and cons of “scaling-in” and highlight the danger of data errors in mean-reverting strategies, especially those that deal with spreads.

Examples of mean-reverting strategies will be drawn from interday and intraday stocks models, exchange-traded fund (ETF) pairs and triplets, ETFs versus their component stocks, currency pairs, and futures calendar and intermarket spreads. We will explain what makes trading some of these strategies quite challenging in recent years due to the rise of dark pools and high-frequency trading. We will also illustrate how certain fundamental considerations can explain the temporary unhinging of a hitherto very profi table ETF pair and how the same considerations can lead one to construct an improved version of the strategy. When discussing currency trading, we take care to explain why even the calculation of returns may seem foreign to an equity trader, and where such concepts as rollover interest may sometimes be important. Much emphasis will be devoted to the study of spot returns versus roll returns in futures, and several futures trading strategies can be derived or understood from a simple mathematical model of futures prices. The concepts of backwardation and contango will be illustrated graphically as well as mathematically. The chapter on mean reversion of currencies and futures cumulates in the study of a very special future: the volatility (VX) future, and how it can form the basis of some quite lucrative strategies.