An Intro to Quant Models: Part 4

This article forms part of a series by CEO Sam Barry on Quant Models. To read the first three parts, follow the links below:

Following on from my last article on the types of trading strategies we can really use in quant systems, I want to talk to you about building them – and then managing risk.

This is where we start to get a lot of variation between different quant shops and what principles drive them, however all of them have a set of principles that they will adhere to, and very often these are the principles of the lead manager at the firm.

When building a trading system though there are a few things to consider:

  1. Who is it for?
  2. What risk can they take?
  3. What is the overall aim?

Now, for many who start out in trading, they often get confused by these. An example is that most people often say they are looking for total return.

My challenge to them then is whether they would take a 50% drawdown for  200% annual return, with that annual return happening all in one day towards the end of the year? This is obviously an extreme case, but if you consider a system that might be breakout trading and there is no real breakouts until a major event (say Russia declares a 17% interest rate) then actually it is not as far from the potential reality as it may sound.

Typically most new traders are actually after consistency – earning a consistent steady return.

Very frequently they can’t take the rollercoaster ride that naturally occurs.

So if you can define the key points above, then you at least know what your trading system needs to do. Some need to trade volume, some need to trade frequently, some need to sit there and wait for the perfect moment to strike.

With these principles, you will start to focus your other models on what you want to achieve. Unfortunately, this typically also means that you will naturally rule out certain investors into your systems.

For instance, trend-following systems don’t typically suit retail or unsophisticated investors who like to see activity and prefer to see small wins over holding onto positions which can change intraday.

That may seem an unfair generalisation, but often the challenge with trend-following systems is that you need to be in it for the longer run and leave it alone. Performance intraday can seem choppy, but over long run averages it comes out extremely strong and retail or unsophisticated investors typically want to see activity and movement as they end up watching systems very closely.

In these cases, often breakout or scalping systems are better options, but again you can prove that in the longer run these aren’t normally as profitable (I say “normally” there are always exceptions in the patterns).

This is really something you need to accept.

Far too often though I see new people focusing on short-time high risk systems which, actually, if they did turn on they’d struggle to stomach the ride and would end up turning them off most likely just before they did extremely well.

Once you have your principles and focus for your system, it then becomes about an unwavering need to constantly improve it until you can’t get any more out of it.

I often tell people that we are only 2% into the improvements we can make on our systems. There is an abundance of possibilities when it comes to making enhancements. It might seem hard to believe but with even the most basic trading system (typically the best in my experience) are able to be tweaked, modified and improved in order to squeeze that little bit more out of it.

However the key to doing this often comes with risk management.

Where you can make or break a strategy really is in the risk management. Now I don’t just mean where you put stop losses, I mean a broader term of risk management.

  • How do you manage your positions?
  • What rules define good and bad trades to take?
  • How do you balance your risk exposure?
  • What calculations do you use to determine your total risk?

And many more beyond are all key questions to answer.

These questions and the implementations of them and many more questions like them will determine how your trading system behaves in totality and how well it works alongside other investments.

This latter question is actually surprisingly important. There is no point having a really good complex trading strategy that is able to produce the performance of the SP500 using currencies if it is perfectly correlated, as you might as well just buy into a low cost index tracker of the SP500.

When you start to see the total picture and how all the individual components work together, this is where the real complexity in these systems lies.

The trading system could be as simple as a moving average cross, but once you overlay the various models and risk management systems and their key metrics, you get to a very finite set of systems that will work well.

For us, these key components result in one of our most prized assets.

Our portfolio builder and risk system is one of the key components that gives us a differentiator, and obviously I have no intention of telling many people how they work!

But this is where a lot of new traders get their focus wrong.

If you get the trade management and risk models right, profitable trading strategies that fit your principles are easy to find.

Stay tuned for Part 5, all about measuring performance. Meanwhile you can catch up with my previous articles on the subject of quant models here:

Got a question for Sam? Tweet him directly at @LFXSam or contact us here

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