Modelling Trading Strategies In Equities Presentation

B y Q u a n t I n s t i
Copyright © 2017 QuantInsti.com All Rights Reserved.1
November 2, 2017

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About Quantra
• An e-learning portal by QuantInsti™ that specializes in
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• Offers self-paced Courses - mix of videos, audios,
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students to learn and implement complex concepts easily

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• Researcher at IBM T. J. Watson Lab in machine learning (‘94-
’97).
• Quantitative researcher/trader for Morgan Stanley, Credit
Suisse, and various hedge funds (‘97-’05).
• Principal of QTS Capital Management which manages a hedge
fund as well as client accounts.
• Author:
– Quantitative Trading: How to Build Your Own Algorithmic Trading
Business (Wiley 2009).
– Algorithmic Trading: Winning Strategies and Their Rationale (Wiley
2013)
– Machine Trading: Deploying Computer Algorithms to Conquer The
Markets (Wiley 2017)
• Blog: epchan.blogspot.com
About Dr. Ernest Chan
Copyright © 2017 QuantInsti. All Rights Reserved.

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• Directional trading
– Each instrument’s signal is independent of another’s.
• Pairs and other cointegrated portfolio trading
– Signals depend on relative value between 2 or more
instruments.
• Index arbitrage
– Signals depend on relative value between a basket of
instruments and an index future.
Types of StatArb Strategies?

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• Long-short portfolio
– Signals depend on an instrument’s ranking within its universe.
– Ranking based on “factors”
• Factor models
– Signals depend on expected return from a linear combination of
fundamental or statistical “factors”
• We will focus on pairs, and a bit of index arb and long-short
models.
• We will focus on mean reverting strategies.
Types of StatArb Strategies?

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• Stationarity
– A time series is stationary if it doesn’t* wander off to
infinity.
– A random walk is not a stationary series.
• E.g. The price of GLD (gold ETF) is a geometric
random walk, and is not stationary.
• See graph ...
Theoretical Foundation Of Pair
Trading

Example of Non-Stationary series
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0
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20
30
40
50
60
70
80
90
GLD

Another example of Non-
Stationary Series
9
0
10
20
30
40
50
60
GDX

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Example of
Stationary Time Series

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• If the price (or market value) of an instrument is
stationary, we can profit easily by a simple mean-
reverting strategy.
– Buy low and sell high!
Stationarity

• The change of the price series in the next period is
proportional to the difference between the mean price
and the current price.
• ADF tests whether we can reject the null hypothesis that
the proportionality constant is zero.
Testing for Stationarity: ADF Test

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• Individual instrument’s prices usually not stationary.
• Sometimes, holding a portfolio of 2 or more non-
stationary instruments may result in a stationary
portfolio.
– If so, these instruments are said to be cointegrated.
Cointegration

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• Example of a portfolio of possibly cointegrated stocks:
– Long 1 share of GLD
– Short 1.63 shares of GDX
Cointegration

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GLD vs GDX cointegrated?

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• Cointegrating stocks
– stationary portfolio
– mean-reverting strategy
– buy when portfolio MV is low, sell when MV is
high!
Cointegration

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• Correlation is concerned with whether daily (or hourly,
weekly, monthly, etc) returns of 2 stocks are in same
direction.
• Cointegration is concerned with whether 2 price series
diverge over long term.
• E.g. KO and PEP have daily returns with correlation
coefficient of 0.48, but they do not cointegrate.
Cointegration ≠ Correlation

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KO vs PEP: correlated but not
cointegrated

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Correlated Returns

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Cointegrated Prices

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• Cointegration is long-term.
• Correlation is short-term.
• Cointegration is about prices.
• Correlation is about returns.
Cointegration vs. Correlation

• Bollinger bands
• Enter into a position only when the price deviates by
more than a standard deviation.
• Exit when price mean reverts.
Mean Reversion Strategies

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Mean-Reversal Strategy

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Mean-Reversal Strategy

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• Stationarity and cointegration are important for mean-
reverting pair-trading with longer holding period.
• Short-term mean-reversal trade can be profitable even
without cointegration.
• Stock pairs are quite unstable w.r.t. cointegration.
Summary

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Course on Quantra
Mean Reversion Strategies
By Dr. Ernest Chan
Next Steps

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Special 25% discount on the course,
just for webinar participants
coupon code:
WEB25
Valid until Midnight GMT, November 7, 2017.

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Questions?

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