Quantitative trading and
backtesting
28 July 2016
CERN Finance Club
c.laner@cern.ch
Contents
1) Introduce quantitative trading and
backtesting from a theoretical point of view
2) Show how to implement in Python a
backtesting environment for simple trading
strategies
Quantitative trading
Also called systematic trading or algorithmic trading
Creates a set of rules to generate trade signals and
risk management of positions with minimal manager
intervention
Attempts to identify statistically significant and
repeatable market behaviour that can be exploited to
generate profits
Low-frequency (weekly, daily) through to highfrequency (seconds, milliseconds...)
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Quantitative trading system
Four major components of a quantitative trading
system:
1) Strategy identification
2) Strategy backtesting
3) Execution system
4) Risk management
Focus on first two, last two wont be covered here
Strategy identification
Research strategies in blogs, forums, journals, etc. For
example:
Journal of Investment Strategies
Quantpedia.com
Many more (GIYF)
Many of these strategies are either not profitable anymore
or only slightly profitable (they get crowded or
arbitraged away)
Key to making them highly profitable is to build on them,
e.g. adapt them to new market conditions or optimise
their parameters
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Strategy identification
Two main categories of strategies:
Trend-following: Trades on momentum, i.e. on the basis
of the slow diffusion of information
Mean reversion: trades on the deviation of a stationary
time series (price or spread) from its expected value
Range of trading frequencies
Low frequency trading (LFT): days-years
High frequency trading (HFT): intraday
Ultra high frequency trading (UHFT): secondsmilliseconds
High frequency trading requires detailed knowledge of
market microstructure (how the order book and exchange
work)
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Backtesting
Once a strategy is identified, need to test its performance
using historical data as well as out-of-sample data
Data
Many types: fundamental, OHLC, sentiment, news
Many frequencies: intraday, daily
Many instruments: equities, futures
Many sources: many are expensive, but there are a few good
free sources, e.g. Yahoo Finance, Quandl
Qualities of good data:
Clean and accurate (no erroneous entries)
Free of survivorship bias (see next slide)
Adjusted for stock splits and dividends
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Backtesting
Biases
Biases tend to inflate performance. A backtest is likely an upper
bound on the actual performance
Optimisation bias
Over fitting the data as a result of too many free parameters
Strategy will fail with real data
Lookahead bias
Introduction of future information into past data
e.g. using the days high/low, calculating a parameter using
data that would not have been available at the time
Survivorship bias
Using only instruments which exist at present
Companies that went bankrupt would have made your
performance worse
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Backtesting
Transaction costs
Backtest performance is inflated if transaction costs are not modelled
appropriately
Commissions/fees
A commission is paid to the broker for every transaction
Bid-ask spread is also important, especially for illiquid instruments
Slippage
Price difference between time of trade signal and time of order fill
Depends on the volatility of the asset and the latency between the
trading system, the broker and the exchange
Especially important for HFT
Market impact
Placing large orders can move the market against you
May want to break the transaction into smaller chunks
Execution and risk management
The last two components of a quantitative trading system
would entail a whole other talk. Very briefly:
Execution system
Generates trades in real time
Provides an interface to the broker (e.g. via an API)
Risk management
Decides how to act on trade signals
Controls leverage
Assigns capital to trades or strategies as optimally as
possible
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Analysing performance
Some common measures of performance
Compounded growth rate
Usually annualised, gives the average annual return
Volatility
Usually annualised, given by the standard deviation of annual
returns
Measure of risk
Sharpe ratio
Measure of reward/risk ratio
Usually annualised and measured with respect to a benchmark b
(e.g. risk-free rate or S&P500)
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Analysing performance
Some common measures of performance
Drawdown
A period of time in which
equity is below the highest
peak so far
Can calculate maximum
drawdown and maximum
drawdown duration
Alpha, Beta
Fit a straight line (security characteristic line) to strategy returns
against the returns of a benchmark (e.g. S&P or the market)
Beta is the gradient the variance/correlation with respect to the
market i.e. gives a measure of systematic risk (want beta ~ 0)
Alpha is the intercept the excess return over the market, i.e. a
measure of performance (want large positive alpha)
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Python backtester
Lets put this into practice with Python
My backtesting code:
www.github.com/Xtian9/QuantCode *
Disclaimer: Very simple and incomplete
Feel free to use it or contribute!
Makes use of pandas, numpy, and matplotlib
Employs vectorised calculations as opposed to an eventloop (so less realistic as a simulation, but handy for doing
quick research)
* Inspired by:
www.quantstart.com
www.github.com/quantopian/pyfolio
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Python backtester
Components of the backtester
Data handler
Downloads OHLC data from Quandl
Strategy
Generates signals for each day
+1 long, -1 short, 0 cash (no position)
Portfolio
Generates/rebalances positions
e.g. assign equal dollar weights to all assets
Computes returns (potentially for risk management)
Analyser
Analyses the performance of the backtest
e.g. equity curve, Sharpe ratio, etc.
Still missing: transaction costs, risk manager
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Moving average crossover
Lets look at a hello world example strategy
Moving average crossover
This is a momentum strategy
Strategy rules:
Create two simple moving averages (SMA) of a price series with
different lookback periods, e.g. 9 days and 200 days
If the short MA exceeds the long MA then go long
If the long MA exceeds the short MA then go short
Short
Long
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Config file
backtests/macross/macross_cfg.py
Choose trading parameters: tickers, dates, frequency, window lengths
Initialise strategy, portfolio, analyser and backtest classes
Run the backtest!
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Data handler
The DataHandler class fetches data from Quandl and returns a
pandas DataFrame of prices, e.g.
The Backtest class then creates empty signals and weights
DataFrames that need to be filled by the Strategy and
Portfoflio classes, respectively
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Strategy class
strategies/macross.py
Create a MovingAverageCrossoverStrategy that inherits from Strategy
Implement a generate_signals method that fills in the signals
DataFrame
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Portfolio class
portfolios/equalweights.py
Create a EqualWeightsPortfolio that inherits from Portfolio
Implement a generate_positions method that fills in the
weights DataFrame
If weights sum to 1, total return of portfoflio is the weighted
average of the assets returns
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Analyser class
analysers/performance.py
Generic Analyser that computes performance measures like
Sharpe ratio, drawdown etc. and makes performance plots like
equity curve etc.
Can also create and add additional Analyser sub-classes to the
backtest
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Analyser class
Performance plots
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Outlook
Would like to expand on this to build a more sophisticated
quantitative trading system with many improvements:
Event-driven backtesting
Realistic handling of transaction costs
Risk management framework
GUI?
Real time execution
As well as doing actual quant research
Would anyone like to work on this together?
We could set up a quant trading or quant research
arm within the club
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Bibliography
Michael H. Moore
www.quantstart.com
Ernest P. Chan
Quantitative Trading: How to Build Your Own
Algorithmic Trading Business
Ernest P. Chan
Algorithmic Trading: Winning Strategies and Their
Rationale
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