Preamble
Preface
- Systematic trading and investing
- Who should read this book
- Overview - what is coming
Introduction
- September 2008: The Billion Dollar Day
- January 2009: Why (most) humans make poor traders
- The black box is simpler than you think
- An open source revolution
- An open source systematic framework
PART ONE: THEORY
The good, the bad and the ugly of systematic trading
- Humans should be great traders - in theory
-- The death of rational economic man
-- Why we run losses and stop out profits
- Introducing a systematic rule for trading
-- Stick to the rules and don't meddle
-- Overcoming instinct - why 'contra' instinctive behaviour works
-- Why subjective 'systems' don't work
- Commitment mechanisms - how do we stop ourselves 'meddling'?
-- Automation - the use of dogs in finance and engineering
- Systematic trading in financial institutions
The commitment problem does not go away...
-- . but there are benefits
- The ideal systematic trading shop
- Two more tricks to reduce meddling
-- Abstraction
-- Ignorance
- Designing systems to discourage meddling - the three virtues
-- Trust your system
-- Understand the limits of your ignorance
-- Sleep at night: Position size is as important than position sign
- When is meddling acceptable?
-- Unacceptable meddling
-- Acceptable meddling
- Irrationality in trading system development - the three sins
-- Overfitting
-- Overtrading
-- Overbetting
Systematic strategies
- Why do strategies 'work'?
-- Risk premia
-- Frictions and barriers to entry
-- Information less trading
-- Returns to effort and cost
-- Behavioural effects
-- Pure alpha:skill
- What makes a good strategy?
-- Intuitive
-- Well motivated
-- As simple as possible
-- Can be systematised
- Categorising the strategy universe
-- Static versus Dynamic
-- Buying and selling insurance
-- Technical vs fundamental
-- Fast vs Slow
-- Directional vs cross sectional
-- Low versus high leverage
-- Many positions vs few positions
-- Crowd following vs contrarian
PART TWO: THE TOOLBOX
- Model selection, calibration and fitting
-- The perils of overfitting
-- Distinguishing dud models from good models
-- Fitting and overfitting
- Four rules for effective fitting
-- Start with a small number of ideas, not with data
-- Save real data for a rainy day; use artificial data
-- Don't fit unless there is a gun to your head
-- If you must fit to real data, be very, very careful
- Portfolio allocation
-- Anecdote: When smart people make stupid decisions
-- The bad news: Portfolio optimisation is hard
-- A simple fix: bootstrapping
-- 'Handcrafting' the weights: The heuristic method
-- Some problems
-- The good news
PART THREE: THE FRAMEWORK
An 'open source' framework for systematic trading and investing
- Why an open source framework?
-- Parallels with open source software
-- Flexibility
-- Individual seperable components with well defined interface
-- Underlying logic exposed â+' easily modified
- The elements of the framework
-- Instruments to trade
-- One or more signals
-- Forecasts - combinations of signals
-- Scaled positions
-- Portfolios of positions
-- Total capital scaling - money management
-- Risk measurement and control
- Modifying and extending the 'open source' framework
Instruments - the building blocks
- Asset classes: Stocks, bonds, ETF's, futures, CFD's ...
- The character of different instruments
- Portfolios as instruments
- Spreads - a special kind of portfolio instrument
- Summary - key points
Signals - looking under the hood
- What is a signal?
- What properties should signals have?
-- A signal is a scaled quantity
-- But what scale
-- Why it makes sense to have a unit variance signal
-- Are jumpy signals okay?
-- Should we allow signals to be as large as possible?
-- Three signals in detail
-- Summary
From signals to forecast
- Combination
-- Linear versus non linear
-- Choosing the weights - we need portfolio optimisation
-- The diversification multiplier
- Mapping function
-- Binary
-- Linear
-- Linear with cutoffs (recommended)
-- Linear with flat spot
- Summary - the default system does...
Position scaling
- The magic number
- Position is signal over standard deviation
- Expected volatility
-- How do we measure expected volatility?
-- Dangers of low volatility
-- A rule for low volatility
- Summary - the default system position scaling is...
Instrument weights - more portfolio allocation
- Linear weighting for portfolios
- Portfolio optimisation amongst instruments
-- Which grouping for the heuristic?
-- Multiple dimensions
-- Portfolios of spreads
- The diversification multiplier, part two
- Summary
Total capital scaling: Risk appetite and money management
- How much can you lose?
- A brief primer on the Kelly Criteria
- From Sharpe to Kelly
- The total capital scaling rule
-- Low risk target, high worst loss; or high risk target, low worst loss?
-- Upside ratcheting and downside adjustment
- Special cases: Interest paying, living off the proceeds and principal protection
- Summary
Risk measurement and risk control
- Some risk management issues
-- What is risk and how do we measure it?
-- Risk that's hard to measure
-- Two key flavours of system for risk management
- Built in risk management
-- Risk managing at a signal level
-- Risk managing at an instrument level
- System level risk management
-- Maximum estimated risk
-- Correlation risk - the perfect storm
-- Jump risk redux - low volatility
-- Combining them - the worst case scenario multiplier
-- The clipping problem
- Outside the system - the risk envelope
-- The risk envelope exists to avoid meddling
-- Measuring the envelope
-- Applying the envelope
- Buying an insurance against poor performance
- Summary
Tailoring
- Speed of trading
-- Calculating the damage from trading too quickly
-- Decomposing and calculating the cost of trading
-- Applying the brakes - how to slow down
-- Costs and calibration
-- Some subtleties
- Trading with more or less capital
-- Trading with more capital
-- Trading with less capital
PART FOUR: PRACTICE
Example one: Systematic trading for discretionary traders
- Why use a systematic framework with discretionary decisions?
-- Instruments
-- Signals
-- Forecasts
-- Position scaling
-- A 'portfolio' of trades
- Total capital scaling
- Risk control
- Worked portfolio example
- Extensions
Example two: Systematic asset allocation; a long only risk parity portfolio
- A risk parity system
- Instruments to trade
- World's dullest signal and forecast
- Position scaling
- Portfolio construction - the difficult part
-- Bootstrap method
-- Heuristic method
- Total capital scaling
- Risk control
- Worked portfolio example
- Extensions
Example three: Fully systematic futures trading system
- A futures system
- Instruments
- Signals
-- Momentum
-- Carry
- Combining signals to get forecasts
-- Cost estimation
-- Heuristic
-- Bootstrapping
- Position scaling
- A portfolio of instruments
-- Heuristic
-- Bootstrap
- Total capital scaling - the dangers of easy leverage
- Risk measurement and control
- Worked portfolio example
- Extensions
Appendices
Appendix A: Resources
Further reading
Data sources
Brokers and platforms
Coding
Appendix B: Formulas
Backtesting
- Accounting
- Costs
- Judging the results
-- Sharpe ratio
-- T- test
-- Skew
Fitting
Iterative binary grid search
Portfolio construction
- Markowitz portfolio optimisation
- Bootstrapped portfolio optimisation
- By hand portfolio optimisation
-- Means
-- Costs - specific case of means
- Linear portfolio weighting and calculating the diversification effect
- Nearest portfolio
Signals
- Random entry stop loss
- Flip flop stop loss
- Basic moving average crossover
- Exponetial moving average crossover
- Raw carry signal for generic asset
- Raw carry signal futures contracts
- Smoothed carry signal
From signal to forecast
- Individual signal scaling
- Linear signal combination and calculating the diversification effect
- Forecast mapping functions
- Linear with cap
-- Binary
-- Cutoff
- Position scaling
-- Volatility estimation
- Minimum volatility rule
- Final position calculation
- Portfolios of instruments
- Total capital scaling
-- Establishing the initial scalar
-- The auto ratchet down
-- The manual ratchet up
- Risk measurement and control
-- Natural risk scalar
-- Vol shock risk scalar
- Correlation shock scalar
- Total risk scalar
- System performance envelope

Systematic Trading

A Unique New Method for Designing Trading and Investing Systems