A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.

2019, 12:49

Alternative Data Data Monetization Industry Trends API Usage

Data Trends for Investment Professionals GO TO QUANDL.COM ⟶

Guides Weekly Newsletter Archives

A Quant’s Approach to
Building Trading Strategies:
Part Three
BY:RAQUEL SAPNU INDUSTRY TRENDS FEB 24 2016 Tags: Quantitative analysis

This is the third part of our interview with a senior quantitative

portfolio manager at a large hedge fund. In the first part, she discussed
the theoretical phase of creating a quantitative trading strategy. In the
second part, she described the transition into “production.”
This interview received so many excellent questions that we’ve dedicated
an entire post to the answers.

You can read the first part of the interview here and the second part of
the interview here. Readers’ questions have been lightly edited for
clarity.

1. How do you monitor and manage your model once live? What
additional checks and procedures do you use?

I’m a big believer in manual PL reconciliation as a diagnostic tool. I like

to know, every single day, exactly where my PL is coming from. What
richened, what cheapened, by how much, and why. This gives me
https://blog.quandl.com/interview-with-a-quant-part-three Strona 1 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

confidence that the model is working as designed, and it serves as an

early warning system for bad news.

Next: on my desk we use a “trading buddy” system where one of the

other traders knows everything there is to know about my model and
positions. He/she also tracks my trades every day, so that’s an extra,
independent pair of eyes.

Finally: I try not to recalibrate my model too often. That’s a slippery

slope in the direction of curve-fitting. But I do try to second-guess
myself all the time: question my macro assumptions, talk to people with
contrarian points of view, and so on.

The combination of watching my own trades like a hawk, and conversing

with intelligent, skeptical colleagues and counterparts seems to work
pretty well for me. I’m sure there are other ways to do it.

(None of the above, by the way, should be construed as a replacement for

an excellent and independent risk management team, or for desk-level
monitoring.)

2. Do you set up predefined monitoring rules or circuit breakers

that take the model out of action automatically? If so, how do
you construct these, what kinds of measures do you use in them?

I’m kind of old-fashioned — I don’t believe circuit breakers really work.

Or to be more precise, portfolios with programmatic circuit breakers
underperform portfolios without, over the long term. The reasoning is
that circuit breakers stop you out of good trades at a loss way too often,
such that those losses outweigh the rare occasions when they keep you
out of big trouble.

https://blog.quandl.com/interview-with-a-quant-part-three Strona 2 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

(If you could somehow calibrate your circuit breaker to only stop you out
of catastrophes, you’d e!ectively have built a “max-deviation-indicator.”
As with perpetual motion machines, this is a reductio ad absurdum
argument.)

Note that I’m talking about classic quant arb portfolios here, not
electronic execution or HFT. In the latter cases, I can totally see why
you’d want multiple fail-safes and circuit breakers — those books can get
away from you really fast. But that’s not my area of expertise.

Within my area, I’ve observed a few patterns in models that break. For
starters, they rarely blow up instantly. Instead, either the opportunity
just gradually disappears (arbitraged away by copycats), or the spread
slowly and imperceptibly drifts further and further away from fair value
and never comes back (regime change).

Conversely, if a trade diverges and then the divergence accelerates, that

smells to me much more of a capitulation. In those cases, I want to hold
on to my position and indeed add if I can.

So the paradoxical conclusion is that the faster a model loses money, the
more likely it is to be still valid.

EXCEPT if the losses are due to a clear exogenous event — China

changing the Renminbi peg, or Iraq invading Kuwait, for example. In that
case you’d expect rapid losses and no immediate prospects of a recovery.
So you want to stop out.

Good luck programming a coherent circuit breaker to handle that logic!

This is actually a microcosm of the larger problem. A situation where a

circuit breaker would help will almost definitely be one perverse enough

https://blog.quandl.com/interview-with-a-quant-part-three Strona 3 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

to avoid most a priori attempts at definition.

3. How do you determine if the model is dead or just having a bad

time? Do you know of any useful predictive regime change
filters?

This was the single most commonly asked question. And I’m afraid I’ll
have to disappoint everyone: I don’t know the answer. I wish I did!

For me, I use a variety of rules of thumb. Statistical tests to make sure
the meta-characteristics of the model remain intact. Anecdotal evidence
of capital entering or leaving the market. Other people’s positions and
pain. Price action: is it nervous and choppy, or dull and arbed out? And
so on.

I’ve yet to find a reliable, universal, predictive (or even

contemporaneous) indicator of regime change/model death. Sad, but
true.

4. Model deaths seem to last a period of years then come back

better than ever sometimes. Do you keep tracking “dead” models
and will you bring them back after a “revival”?

Absolutely, and this is a great point. Models do come back from the dead.
US T-note futures versus cash is a classic example: it cycled between
“easy money”, “completely arbitraged out”, and “blowup central” three
times in my trading career. Same science in each case; all that changed
was the market’s risk appetite. So I never say goodbye to a model forever;
I have a huge back catalogue of ideas whose time may come again.

5. What do you think of taking a more “gradual” approach to

monitoring where instead of classifying models as either dead or

https://blog.quandl.com/interview-with-a-quant-part-three Strona 4 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

alive (binary), you scale the amount of capital committed to each

model, depending on aggregate model performance? So you’re
never completely out of the market but at the same time you
don’t devote capital to moribund strategies.

Yes, this is an interesting idea. I’ve seen PMs experiment with

“Darwinian” risk allocation techniques, putting more money into
successful strategies and taking money out of losers. To an extent, every
good PM does this, but some are more rigorous than others. And at least
one big shop that I know of is completely and unequivocally run this way.

6. What do you think of money management rules such as

optimal betting size?

I’m aware of the literature on this (Kelly criterion and its descendants),
and by and large my positions are consistent with those rules. But I use
them as a sanity check, not as a primary determinant of positions.

7. Are either quantitative or technical strategies giving you

consistent “comfortable” returns? Do you rely on one system or
do you keep changing systems arbitrarily?

You have to keep evolving with the markets. No single system or strategy
works forever.

8. I observe that you have already used Matlab, Python and Excel
(and presumably use C#/C++/Java) for production. Isn’t the
process of shifting between di!erent languages (like Matlab,
Python, C#/C++/Java 4) cumbersome?

It’s not that cumbersome. I typically find that the most tedious part is
making sure the data "ows consistently and smoothly between di!erent

https://blog.quandl.com/interview-with-a-quant-part-three Strona 5 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

apps or languages. Syntax translation is easy; data translation, not so

much.

9. What can you do in Matlab that you cannot do in Python or

vice versa?

These days, you’re right, there’s not much you cannot do in Python. And
indeed I find myself using Python more and more. But that was not
always the case; the plethora of open-source financial libraries in Python
is a relatively recent phenomenon.

10. Regarding Excel, don’t you find that even though

visualization is useful, it carries a lot of operational risk
(formulas not being dragged correctly, sheet not refreshed
properly, etc.)?

I totally agree. Excel is fragile in many ways. It’s easy to make operational
mistakes, it’s impossible to audit, it’s not very performant, it hangs at the
most inconvenient times. So you have to be very careful in how and
where you use Excel. That said, I do find the benefits outweigh the many
costs.

11. What kind of turnaround time do you expect from

engineering colleagues coding up your strategy in C or Python?
Both for the first cut implementation, and then fixes and
enhancements?

Depends on the strategy. I’d say the median is 4-5 weeks for the first cut,
and maybe another 2-3 weeks for fixes and tweaks. Some strategies are
simpler and can be brought live in a matter of days. On the other hand, I
remember one particular strategy that took several months to
instantiate. It turned out to be super profitable so in that case it was

https://blog.quandl.com/interview-with-a-quant-part-three Strona 6 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

worth it, but in general I’d want to move a lot faster than that.

Make no mistake: once you’ve found a new source of alpha, the clock is
ticking. You’re in a race to extract as much PL as possible before the
opportunity fades away.

12. I found this comment interesting: “For instance, I calibrate

on monthly data but test on daily data.” I guess it depends on
what you mean by “calibration” but this struck me as slightly
unusual.

Let’s make it simple and suppose I’m trying to capture (slow)

trends using a moving average crossover. I play around with
monthly data until I get something I think works. To move to
daily data I ought to multiply some parameters by ~20 (like the
moving average lengths) because there are about 20 business
days in a calendar month, and others by ~sqrt(20) [various
scaling parameters too dull to discuss here]. But the model
should still behave in the same way. The turnover, for example,
shouldn’t increase when I move to daily.

On the other hand, if I keep the parameters the same, then instead of
picking up, say, a six-month trend, I’m picking up a six-business day
trend. But the sweet spot for trend following most assets tends to be a
fair bit slower than that so it’s unlikely to look as good. Also my turnover
will be a lot higher, but then you’d expect that. To put it another way, I’m
not sure all aspects of market behaviour are “fractal” such that I can just
apply exactly the same model to di!erent time scales.

Are markets fractal? Great question and one I’ve spent many evenings
debating.

https://blog.quandl.com/interview-with-a-quant-part-three Strona 7 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

Personally, I think they’re not, because certain exogenous events act as a

forcing function: daily margin calls from exchanges, monthly MTMs for
hedge funds, quarterly financial statements for publicly traded banks.
These events cause something to happen (never mind what) at those
frequencies. So not all time-scales are created equal, and merely
speeding up/slowing down the clock is not a “neutral” approach.

So I’m actually very cautious about which strategies I’d do this kind of
time-shifting with.

Here’s a toy strategy where time-shifting can work. Take two futures
strips in the same space — maybe winter and spring wheat. Look for
cases when one is backwardated and the other is in contango. Buy front
low, sell back high, sell front high, buy back low. A totally simple, almost
“dumb” strategy, but for many futures pairs it used to work well.

This is a great case for changing time scales. This strategy should work
whether you sample/rebalance weekly, or monthly, or quarterly —
because the decision variables are pure state, no path. We’re not looking
at price histories; nor are we looking at instruments with a time
component (bonds which accrue, or options which decay, or random
walks with a drift). So, given that the strategy is really clean, we can get
away with this kind of robustness test.

(Caveat: bid-ask is the one complicating factor here — your chosen time-
scale needs to be big enough to allow for price action that overcomes
friction. Bid-ask is the bane of quants everywhere.)

But I would never apply this same test to, say, a trend-following strategy.
That would raise all sorts of philosophical questions. What does it mean
for a strategy to have a “sweet spot” at say nine days, or 200 days, or
whenever? By optimizing for that sweet spot, are you curve-fitting? Or

SHARE
https://blog.quandl.com/interview-with-a-quant-part-three Strona 8 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

SHARE
does the fact that almost everyone uses 9d and 200d create a self-
fulfilling prophecy, and so those numbers represent something
structural about the market? I’ve heard convincing arguments both
ways. What if you sampled your data at interval X, and then did 9X and
200X moving averages — would that work? Fun philosophical questions.
I’m not sure of the answers myself.

Other notes: I agree that “calibration” was a sloppy choice of word by me

in that particular sentence. “Ideation” would have been better. If you’re
calibrating, you’re already introducing more structure than time-
shifting can safely handle.

13. Could you give more details on the use of Monte Carlo in
parameters initialization?
For most optimizations, I need to have a vector of initial guesses for the
parameters – the “starting point” for my n-dimensional gradient
descent. The problem is, non-linear systems tend to have local minima
which it’s easy to get sucked into. You can use random jumps (“simulated
annealing”) to escape these, but I find that a more robust method is to
re-run the optimization many times but with di!erent starting points. I
use Monte Carlo sampling to generate these starting points: basically,
pick random values for each parameter (consistent with that parameter’s
distribution characteristics).

14. How do you scale your trading strategy? How much gain per
transaction would be considered a good model? And on what time
scale is it trading? What range of time scales are used in your
industry? How much money can there be poured into a successful
scheme, is this limited by how much money your fund has
available or are there typically limits on the trading scheme
itself?
I have a few rules that I try to follow.

https://blog.quandl.com/interview-with-a-quant-part-three Strona 9 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

For a market micro-structure trade, where there’s very little risk of a

catastrophic blow up but the upside is similarly limited, I’d like to make
10x the bid-ask over a horizon of less than a month. If bid-ask is 1bp, I
want to make 10bps with a high probability of success (after financing
costs). The binding constraint on these trades is usually balance sheet: I
need to make sure that the trade pays a decent return on capital locked
up.

For a more macro/thematic trade, I choose my size based on max loss

and PL targets for the year. Bid-ask and balance sheet are less relevant
here; it’s all about how much can I a!ord to lose, and how long can I hold
on to the position. Obviously I use very fat tails in my prognosis.

Incidentally, optimal scale changes over time. I know some of the LTCM
folks, and they used to make full points of arbitrage profit on Treasuries
over a span of weeks. A decade later, that same trade would make mere
ticks: a 30-fold compression in opportunity. You have to be aware of and
adapt to structural changes in the market, as knowledge di!uses.

Regarding time horizons: I personally am comfortable on time scales

from a few weeks to a few months. The two best trades of my career were
held for two years each. (They blew up, I scaled in aggressively, then rode
convergence all the way back to fair value). My partner on the trading
desk trades the same instruments and strategies as I do, but holds them
for a few hours to a few days at most. So it’s all a matter of personal style
and risk preference.

Regarding capital deployment: I work for a large-ish fund, and the

constraint has almost always been the market itself. (Even when the
market is as large and liquid as say US Treasuries.). There’s only so much
you can repo, only so many bids you can hit, before you start moving the
market aggressively against you.

https://blog.quandl.com/interview-with-a-quant-part-three Strona 10 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

15. I was wondering how to interpret “My partner on the trading

desk trades the same instruments and strategies as I do, but
holds them for a few hours to a few days at most.” Is it fair to say
that you are running quant strategies but that the
execution/positioning/rebalancing are done on a discretionary
basis? Or do you mean that he is calibrating his models such that
they take trades in tighter neighborhoods around an equilibrium
value but also have tighter stop outs?

A bit of both. My execution/positioning/rebalancing is largely

discretionary — albeit informed by lots of research and calibration and
thinking about limits. His execution is more mechanistic: he has
programmed a set of rules and just follows them.

Also, we use similar “"avors” of models but they’re not exactly the same.
He does smaller trades for quicker opportunities with tighter stops. And
he’s willing to recalibrate “fair value” much more rapidly than me. In
some specific areas, he’s almost a market-maker (that’s how he defrays
bid-ask). I’m not; I’m definitely a price taker.

16. Do you have advice for someone who just started as a quant at
a systematic hedge fund? How do I become really good at this?
What di!erentiates the ones who succeed from those who do not?
In a nutshell: intellectual discipline. By which I mean a combination of
procedural rigor, lack of self-deception, and humility in the face of data.

Quants tend to get enamoured of their models and stick to them at all
costs. The intellectual satisfaction of a beautiful model or technology is
seductive. It’s even worse if the model is successful: in addition to
emotional attachment, you have to contend with hubris. Then one day it
all comes crashing down around you.

https://blog.quandl.com/interview-with-a-quant-part-three Strona 11 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

The reason I’ve been successful in this industry over decades is that I
have a keen sense of my own ignorance, and I’m not afraid of appearing a
fool. I ask dumb questions, I question everything, I constantly re-
examine my own assumptions. This helps me re-invent myself as the
market changes.

What do you think of our quant’s answers? Leave your questions

or comments below and she’ll respond.

SHARE

RELATED ARTICLES

ALTERNATIVE DATA JUL 11 2019 ALTERNATIVE DATA JUN 04 2019

The Inedible Feast Top 5 Trends in Alternative

Data
So much data, so little alpha A number of
researchers and consulting shops have We are in the fortunate position here at
published projections of just how big the to bear firsthand witness to the
Quandl
alternative data industry is destinedevolution
to be. of alternative data; interactions
Deloitte, for example, concluded that withtheclients, data providers, and immersion
industry will swell to $7 billion nextinyear.
the space combine to give us a unique
They go on to note, "There is no shortage of
perspective. From our standpoint, alternative

https://blog.quandl.com/interview-with-a-quant-part-three Strona 12 z 13
A Quant’s Approach to Building Trading Strategies: Part Three | 29.12.2019, 12:49

ALTERNATIVE DATA OCT 19 2018

Announcing the Third

Annual Quandl Data
Conference
The industry-leading event for data-driven
investing is coming in February. Our co-
founder and Chief Data O!icer Abraham
Thomas shares why he is particularly excited
by this year's conference. We’re so excited to

The Alternative Data Weekly

A Quandl curated weekly newsletter featuring leading thoughts
and opinions surveying the alternative data landscape.
GO TO QUANDL.COM ⟶
Email address Subscribe

https://blog.quandl.com/interview-with-a-quant-part-three Strona 13 z 13