Introduction/ Miscellaneous comments on Quant Trading

- Quant trading is:

 Repeatable
 Encoded in software
 Not necessarily high turn-over strategies
 Allowed to be long horizon
 Focussed on the market impact of trades
 Reliant on processes that are repeatable, well tested and possess forecasting ability.

- A quant manager:
 Can only evaluate information which is systematic.
 Creates portfolios which are diversified, broad, optimized and based on strong signals. These
features are necessary to earn a profit when transaction costs are high.

*** Styles:

Quant Equity:

- Long horizon optimized portfolios driven mostly by slow varying data

- Long short portfolio; Market Neutral
- Turnover at multi-month horizon
- Very similar to fundamental money managers
 Signals used are a combination of value signals (Stock is cheap on some parameter like book to
price) and momentum signals.
- Vast majority of money managed by quant managers falls under this segment
- They were most involved in the Quant melt down of Aug 07
- ***High capacity:
 Quant Equity funds can take on 100’s of millions of $ per client at a time. However, it doesn’t
necessarily possess the best risk/return trade-off or Sharpe ratio.
- Large leveraged positions
- Constrained by risk tolerance
- Returns are earned on positions. Trading is moderately costly.

Statistical Arbitrage:

- Turn-over on a daily, weekly basis.

- Optimized portfolios driven by data that changes throughout the day.
- Capacity constrained.
- Leveraged portfolios of limited size.
- Returns earned on positions; trading is very expensive.

HFT:

- Turnover several times a day.

- Trade list not determined by investor.
- Severely capacity constrained.
- Constrained by trading opportunities.
- Profits from trading. Portfolio composition is more incidental.
- Highly influenced by Equity market structure and regulatory reforms.
 Quant Macro:

- Trading futures, bond, and currency markets.

Analytical Style:

- Convertible bond arbitrage.

- LTCM were analytical managers, doing “smart guy” trades; they weren’t Quant managers.

Random Facts

- Quant Equity Managers and Statistical arbitrageurs are liquidity demanders.

 They decide what they want to trade.
 They pay commissions.

- The High Frequency Traders provide liquidity.

 They place bid and asks in the market and provide market making services.

Factors influencing growth of HFT

- Growth spurred by regulation changes which allowed non-broker dealers to make markets. They
could now quote bids and offers in listed stocks directly.

The Limit Order Display Rule requires that specialists and market makers publicly display certain limit
orders they receive from customers. If the limit order is for a price that is better than the specialist's
or market maker's quote, the specialist or market maker must publicly display it. The rule benefits
investors because the publication of trading interest at prices that improve specialists' and market
makers' quotes present investors with improved pricing opportunities. (from SEC)

- Exchanges provided TAQ (Trade and Quote) data on which enabled tick by tick research

Quant Crisis of August 2007

- Involved the Quant Equity style (long short portfolios, market neutral).

- In Aug 2007, a majority of these funds started to liquidate their positions.

 Over the next few days, portfolios were de-levered leading to huge losses.
 Process started on the 6th.
 Bounced back on the 10th.

- Usually, most quant portfolios have similar characteristics and have significant degrees of correlation
since the drivers like momentum, value etc are common across the board. As such, when one set of
funds started to de-lever, others were forced.
Crisis further explained by the risk of leverage:

In case of high leverage, if you have a certain margin requirements and you lose money, you have to mark to
market; thus, your equity goes down and leverage goes up. Consider the equation:

Leverage = Assets/Equity.

Case 1: Equity=$100; Assets = $500(long) over $500(short) => Leverage = 5.

We can alter leverage by buying or selling assets.

Case 2: Now consider your initial long and short position lost 2% value.

New Equity= $100 – (2* 500*.02) = $80.

Assets are 490/510 but we can average it out and still call it 500/500.

Leverage in this case is 6.25

- This is a problem since people lending you money have certain leverage restrictions. Once you hit
this limit, liquidation is forced (at leverage of 10 in the diagram below).
- Leverage keeps creeping up and if you are faced with liquidating a large portfolio, you need to start
so immediately.
- When everyone starts to unwind, stock prices tend move even more quickly against you. You have to
keep de-levering and shrink asset size and keep Leverage within bounds.
- Market for quant traders have never really recovered after the Aug 7th crisis. This style has gone
enormously out of favour post this crisis.
Equity Market Structure Evolution:

REG(ulation) NMS (***National Market Structure):

Markets voted for speed. REG NMS rewarded speed by protecting quotes at the top of the order book (see
Order Protection Rule below). Before REG NMS, specialists could make money at the cost of investors.

A more formal definition (from wiki):

A series of initiatives designed to modernize and strengthen the national market system for equity
securities." It seeks to foster both "competition among individual markets and competition among individual
orders. Some of the more notable rules include:

1. Order Protection (or Trade Through) Rule - provides inter-market price priority for
quotations that are immediately and automatically accessible.
2. Access Rule - addresses access to market data such as quotations.
3. Sub-Penny Rule - establishes minimum pricing increments.

Some Consequences

- Lead to emergence of co-location and sponsored access as aggressive pricing competition started
between trading venues.

- Most liquidity is non-displayed.

In 2001, 84% of listed securities traded on NYSE. In 2009, it’s only 42%.
***“Traded Upstairs” : Traded by broker dealer and not taken to the exchange floor.

- BATS/ ATS etc provide rebates to people to post bid/offers at their venues.
- Speed is necessary in the competition to provide liquidity. Order queues have a price-time priority.

***Front Running (from investopedia)

Front running is the illegal practice of a stock broker executing orders on a security for its own account while
taking advantage of advance knowledge of pending orders from its customers. When orders previously
submitted by its customers will predictably affect the price of the security, purchasing first for its own
account gives the broker an unfair advantage, since it can expect to close out its position at a profit based on
the new price level. The front running broker either buys for his own account (before filling customer buy
orders that drive up the price), or sells (where the broker sells for its own account, before filling customer sell
orders that drive down the price).

- Doesn’t affect retail folks, since their volumes are so low.

***Colocation: Your servers are placed wherever the exchange servers are placed.

Flash Crash:

- Greek sovereign debt crisis was at a peak.

- Markets were reflecting this anxiety.
- S&P futures were catapulting down due to these macro-economic catalysts.
 - Slow mode: If stocks seem dislocated, trading in the stock is slowed down by the trading venue.
However, due to the slower speed, REG NMS takes the venue off the grid at this moment. This
reduced liquidity.

*** Stub quotes (from wiki)

Order placed well off a stock’s market price. Stub quotes are used by trading firms when the firm doesn’t
want to trade at certain prices and wants to pull away to ensure no trades occur. In order to make this
happen, the firm will offer quotes that are out of bounds. A stub quote also serves as a safety net in that if a
market maker doesn’t have enough liquidity available to trade a stock near its recent price range, then a stub
quote is entered so that the market maker complies with its requirements without extending its quotes
beyond its available liquidity.

- A stub quote is also referred to as a "placeholder" quote because this absurdly priced transaction
would never be reached.

Trade through: A stock market order that is not executed at the best possible price according to quoted prices
at other exchanges.

Regulations/Preventive Measures

- SEC recommended circuit breakers to avoid repetitions.

- Dodd Frank Bill which aims to reduce systemic risk and ending too big to fail!
- Volcker rule which directly affects prop trading.
-

*** NASDAQ, NYSE group, BATS and direct edge are the primary electronic trading venues.