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Quantitative
Trading
Founded in 1807, John Wiley & Sons is the oldest independent publishing
company in the United States. With offices in North America, Europe, Aus-
tralia, and Asia, Wiley is globally committed to developing and marketing
print and electronic products and services for our customers’ professional
and personal knowledge and understanding.
The Wiley Trading series features books by traders who have survived
the market’s ever changing temperament and have prospered—some by
reinventing systems, others by getting back to basics. Whether a novice
trader, professional, or somewhere in-between, these books will provide
the advice and strategies needed to prosper today and well into the future.
For a list of available titles, visit our Web site at www.WileyFinance.com.
Quantitative
Trading
How to Build Your Own
Algorithmic Trading Business

Second Edition

E R N E S T P. C H A N
Copyright © 2021 by Ernest P. Chan. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system,
or transmitted in any form or by any means, electronic, mechanical, pho-
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Limit of Liability/Disclaimer of Warranty: While the publisher and author
have used their best efforts in preparing this book, they make no repre-
sentations or warranties with respect to the accuracy or completeness of
the contents of this book and specifically disclaim any implied warranties
of merchantability or fitness for a particular purpose. No warranty may be
created or extended by sales representatives or written sales materials.
The advice and strategies contained herein may not be suitable for your
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ther the publisher nor author shall be liable for any loss of profit or any
other commercial damages, including but not limited to special, incidental,
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Library of Congress Cataloging-in-Publication Data is Available:
ISBN 9781119800064 (hardback)
ISBN 9781119800088 (ePDF)
ISBN 9781119800071 (ePub)
Cover Design: Wiley
Cover Image: © Jobalou/Getty Images
To my parents, Hung Yip and Ching, and to Ben and Sarah Ming.
 Contents

Preface to the 2nd Edition xi

Preface xv

Acknowledgments xxi

CHAPTER 1: The Whats, Whos, and Whys of

  Quantitative Trading 1

Who Can Become a Quantitative Trader? 2

The Business Case for Quantitative Trading 4
Scalability 5
Demand on Time 5
The Nonnecessity of Marketing 7
The Way Forward 8

CHAPTER 2: Fishing for Ideas 11

How to Identify a Strategy that Suits You 14

Your Working Hours 14
Your Programming Skills 15
Your Trading Capital 15
Your Goal 19
A Taste for Plausible Strategies and Their Pitfalls 20
How Does It Compare with a Benchmark, and How Consistent
Are Its Returns? 20
How Deep and Long Is the Drawdown? 23
How Will Transaction Costs Affect the Strategy? 24

vii
viiiContents

Does the Data Suffer from Survivorship Bias? 26

How Did the Performance of the Strategy Change over the Years? 27
Does the Strategy Suffer from Data-Snooping Bias? 28
Does the Strategy “Fly under the Radar” of Institutional Money Managers? 30
Summary 30
References 31

CHAPTER 3: Backtesting 33

Common Backtesting Platforms 34

Excel 34
MATLAB 34
Python 36
R 38
QuantConnect 40
Blueshift 40
Finding and Using Historical Databases 40
Are the Data Split and Dividend Adjusted? 41
Are the Data Survivorship-Bias Free? 44
Does Your Strategy Use High and Low Data? 46
Performance Measurement 47
Common Backtesting Pitfalls to Avoid 57
Look-Ahead Bias 58
Data-Snooping Bias 59
Transaction Costs 72
Strategy Refinement 77
Summary 78
References 79

CHAPTER 4: Setting Up Your Business 81

Business Structure: Retail or Proprietary? 81

Choosing a Brokerage or Proprietary Trading Firm 85
Physical Infrastructure 87
Summary 89
References 91
Contents ix

CHAPTER 5: Execution Systems 93

What an Automated Trading System Can Do for You 93

Building a Semiautomated Trading System 95
Building a Fully Automated Trading System 98
Minimizing Transaction Costs 101
Testing Your System by Paper Trading 103
Why Does Actual Performance Diverge from Expectations? 104
Summary 107

CHAPTER 6: Money and Risk Management 109

Optimal Capital Allocation and Leverage 109

Risk Management 120
Model Risk 124
Software Risk 125
Natural Disaster Risk 125
Psychological Preparedness 125
Summary 130
Appendix: A Simple Derivation of the Kelly Formula
when Return Distribution Is Gaussian 131
References 132

CHAPTER 7: Special Topics in Quantitative Trading 133

Mean-Reverting versus Momentum Strategies 134

Regime Change and Conditional Parameter Optimization 137
Stationarity and Cointegration 147
Factor Models 160
What Is Your Exit Strategy? 169
Seasonal Trading Strategies 174
High-Frequency Trading Strategies 186
Is it Better to Have a High-Leverage versus
a High-Beta Portfolio? 188
Summary 190
References 192
xContents

CHAPTER 8: Conclusion 193

Next Steps 197

References 198

Appendix: A Quick Survey of MATLAB 199

Bibliography 205

About the Author 209

Index 211
 Preface to the 2nd Edition

W
hen I first started thinking about writing the 2nd edition,
I had a measure of dread. What could I have added that
would be new and interesting? After writing the first draft,
I was relieved, and incredibly excited, at the prospect of sharing with
you my latest knowledge, techniques, and insights, ranging from the
addition of some new functions that make our PCA example run
more than 10x faster, to a novel application of machine learning.
In the 1st edition of this book, published more than a decade
ago, I maintained that independent quantitative traders can beat
­institutional managers at their own game. Many of you have taken
that advice to heart, and many retail quantitative trading commu-
nities and platforms have been built to serve just such an ambition.
But does the premise still hold?
Over the years, many readers reached out and told me how
successful they have been in improving and trading the strategies
I discussed in my books, and others told me how they have simply
been inspired by my books to become successful traders. Our fund
is invested in some of these readers, some of whom have been
managing many millions more dollars than we are. So, the answer to
the above question is a resounding “YES!”
I also exhorted retail traders new to quantitative trading to start
with the simplest strategies (examples of which are described in this
and my previous books). Do simple strategies still work? Or do we
all have to become mathematicians or machine learning experts?
My colleagues and I traded some of the strategies described in
this book live since it was first published in 2009, and ran true out-of-
sample backtests on others, and I was as surprised as they are that

xi
xii PREFACE TO THE 2ND EDITION

many still work after all these years. But the issues of “alpha decay,”
and the even-more-dreaded “regime change,” are ever threatening. I
will talk more about that below.
Speaking of machine learning and artificial intelligence, I didn’t
really think much of those techniques in my first book. In fact, the
only artificial intelligence platform that I described there has gone
out of business. But you may hear that AI is everywhere nowadays,
and many fundamental advances in AI have been made since then.
For example, the dropout technique that gave birth to deep learning
achieved fame in 2012 (Gershgorn, 2017). Should retail traders still
avoid AI/ML?
It is as difficult to apply AI/ML to finance in 2021 as it was in 2009,
but you may be surprised to hear that we have finally succeeded
(Chan, 2020). We have benefited from other giants in the industry
who graciously share their insights and knowledge with everyone
(López de Prado, 2018). We, in turn, tried to make it easier for every
retail trader (even those who are not programmers) to benefit from
this technology by launching predictnow.ai. Here is the spoiler:
The key to successfully apply AI/ML to finance is to focus on
metalabeling – i.e., finding the probability of profit of your own
simple basic trading strategy, and not to use it to predict the market
directly. Why? Your own trading strategy’s past track record is
private; no one else is trying to predict its success. Meanwhile,
millions of people around the world are watching the same public
market, and everyone is trying to predict where it will go. Competition
and arbitrage naturally mean that signal-to-noise ratio is very low
and predictive successes are few and far in between.
But that’s not all. There is another novel use of machine learning
that I will discuss in a completely revised Example 7.1 of this book.
Despite our luck with the longevity of some of the strategies
I described, most arbitrage opportunities eventually fade away—
the notorious alpha decay that professionals like to lament. Alpha
decay can be due to competition—too many people trading the same
strategy, but equally often it is due to regime shift caused by market
structure or macroeconomic changes. Adapt and evolve your strat-
egies, or watch them die (Lo, 2019). The market is not stationary; why
Preface to the 2nd Edition xiii

should your strategies be? The most agonizing decision a quantitative

trader needs to make is to decide when to abandon a strategy dur-
ing a prolonged drawdown, despite repeated efforts to evolve it.
It is ultimately a discretionary decision—you have to judge based
on your market knowledge whether there is a fundamental reason
your strategy stopped working. To gain this market knowledge, you
have to constantly absorb public knowledge disseminated on social
media. That is the reason I set aside an hour each day to go through
my Twitter feed (@chanep). I have highlighted some of the Twitter-
ers I follow in Chapter 2. More so than providing specific strategy
examples, I hope my books will also improve your market intuition
in making these discretionary decisions.
One major addition to this edition is the inclusion of Python and
R codes to every example. Even though MATLAB is still my favorite
backtesting language, there is no reason to exclude the other two
most popular languages. Other things that I added and changed in
the 2nd edition:

Chapter 1: A bit more about fully automated trading and marketing

your strategies to investors. Also, a scare episode during Covid-19.
Chapter 2: Updated the educational and trading resources for bud-
ding quant traders, including the new URL for my own blog.
Also, a good word for Millennium Partners’ founder (not that he
needs it).
Chapter 3: Extensive changes on MATLAB code that remove a major
bug, and new commentary and codes for Python and R. Descrip-
tion of some new quant trading platforms. One item of particular
interest: I discuss a mathematically rigorous way to decide how
much backtest data and how long a paper trading period is
needed. Another mathematical technique was referenced that
determines how data snooping will affect your live Sharpe ratio.
Chapter 4: Much has changed in the world of brokers and infrastruc-
ture providers for algorithmic traders since the first edition.
Even the name of the US regulator for brokers has changed. You
will find them all updated.
Exploring the Variety of Random
Documents with Different Content
presently, when the family will be thirteen without the occasional guest, to
judge from all appearances.
Early in the morning Mrs. Fairfax rises, and cuts bread and butter from
six o’clock till eight; during which time the nursery operations upon the
nine little graces are going on. We only see a half dozen of them at this
present moment, and in the present authentic picture, the remainder
dwindling off upon little chairs by their mamma.
The two on either side of Fairfax are twins—awarded to him by singular
good fortune; and he only knows Nancy from Fanny

THE HAPPY FAMILY.

by having a piece of tape round the former’s arm. There is no need to give
you the catalogue of the others. She, in the pinafore in front, is Elizabeth,
goddaughter to Miss Clapperclaw, who has been very kind to the whole
family; that young lady with the ringlets is engaged by the most solemn ties
to the present writer, and it is agreed that we are to be married as soon as
she is as tall as my stick.
If his wife has to rise early to cut the bread and butter, I warrant Fairfax
must be up betimes to earn it. He is a clerk in a Government Office; to
which duty he trudges daily, refusing even twopenny omnibuses. Every
time he goes to the shoemaker’s he has to order eleven pairs of shoes, and
so can’t afford to spare his own. He teaches the children Latin every
morning, and is already thinking when Tom shall he inducted into that
language. He works in his garden for an hour before breakfast. His work
over by three o’clock, he tramps home at four, and exchanges his dapper
coat for that dressing-gown in which he appears before you,—a ragged but
honourable garment in which he stood (unconsciously) to the present
designer.
Which is the best, his old coat or Sir John’s bran new one? Which is the
most comfortable and becoming, Mrs. Fairfax’s black velvet gown, (which
she has worn at the Pocklington Square parties these twelve years, and in
which I protest she looks like a queen), or that new robe which the milliner
has has just brought home to Mrs. Bumpsher’s, and into which she will
squeeze herself on Christmas day?
Miss Clapperclaw says that we are all so charmingly contented with
ourselves that not one of us would change with his neighbour; and so, rich
and poor, high and low, one person is about as happy as another in Our
Street.
*** END OF THE PROJECT GUTENBERG EBOOK "OUR STREET" ***

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