Course outline. Financial Time Series Analysis. Overview. Data analysis. Predictive signal. Trading strategy

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1 Fnancal Tme Seres Analyss Patrck McSharry Trnty Term 2014 Mathematcal Insttute Unversty of Oxford Course outlne 1. Data analyss, probablty, correlatons, vsualsaton technques 2. Tme seres analyss, random walk, autoregresson, movng average 3. Techncal analyss, trend followng, mean reverson 4. Nonlnear tme seres analyss 5. Nonlnear modellng, regme swtchng, neural networks 6. Parameter estmaton, model selecton, forecast evaluaton 7. Volatlty forecastng, GARCH, leverage effect 8. Rsk analyss, value at rsk, quantle regresson 9. Energy consumpton, demand forecastng 10. Ensemble predcton, wnd power generaton 11. Weather dervatves, ndex-based nsurance 12. Quanttatve tradng strateges, algorthmc tradng Lecture 12 Copyrght 2014 Patrck McSharry Overvew Data analyss and sgnal processng Tradng strateges Constructng an oscllator Buy/sell sgnal Executon Lmt and market orders Data analyss Select a market and fnancal nstrument Choose an approxmate tradng frequency Wll you want to trade monthly, daly, ntradaly or at a very hgh frequency? Download fnancal prces and other avalable explanatory varables whch are relevant to ths partcular tradng frequency Tradng strategy A tradng strategy s a set of rules employed to buy and sell a fnancal nstrument A quanttatve tradng strategy reles on research and data analyss and attempts to remove human emotons from the decson-makng process Algorthmc or systematc strateges can be employed to fully automate the tradng process va order and executon systems Predctve sgnal The bass of any tradng strategy s the exstence of a sgnal whch can be employed to decde when and what sze of poston to take The tradng sgnal, s(t), at tme t s constructed from the nformaton set avalable up to tme t Ths sgnal should have predctve power n the sense that t can forecast future returns wth some degree of accuracy 1

2 Tradng costs Tradng costs refer to the amount of money requred to take a poston (long or short) n a fnancal securty These costs are made up of the bd/ask spread, commssons and slppage Many sgnals can be found to have predctve power but may not have any utlty due to the substantal tradng costs needed to mplement them Techncal tradng rules Brock et al. (1992) Oscllator: s t = EWMA(p t,n s ) EWMA(p t,n l ) Buy (sell) when short perod movng average moves above (below) the long perod movng average Buy when s t > 0 and sell when s t < 0 Could reduce tradng costs usng a band We consder the rule (n s,n l ) = (1,50) assumng tradng costs of 20 bass ponts Strategy llustraton on S&P500 TTR on S&P500 durng Statstcal arbtrage Statstcal arbtrage (StatArb) s based on devatons from some mathematcal measure of far value A tme seres s constructed to reflect possble mss-prcng between a collecton of securtes Short-term mean-reverson strateges are then developed to explot the prce dfferental These strateges typcally requre very short holdng perods (from seconds to days), and requre substantal computatonal, tradng, and IT nfrastructure Statstcal arbtrage approach StatArb often requres a long/short portfolo of hundreds of securtes that are carefully matched by sector and regon to elmnate exposure to market and factor rsk Each securty s assgned a numerc score or rank that reflects ts desrablty; hgh scores ndcate securtes that should be held long and low scores ndcate securtes that are canddates for shortng Ths scorng attempts to dentfy securtes lkely to exhbt short-term mean reverson Securtes are combned nto a portfolo n carefully matched proportons so as to elmnate (or at least greatly reduce) market and factor rsk Ths may be acheved usng commercal rsk models lke Barra/APT/Axoma/Northfeld to constran or elmnate varous rsk factors 2

3 Index arbtrage In stock ndex arbtrage a trader buys (sells) a stock ndex futures contract such as the S&P 500 futures and sells (buys) a portfolo of up to 500 stocks whch consttute the ndex The program trade at the NYSE would be preprogrammed nto a computer to enter the order automatcally nto the NYSE s electronc order routng system at a tme when the futures prce and the stock ndex were far enough apart to make a proft Pars tradng Pars tradng was ntally developed n the late 1980s (Nunzo Tartagla, Morgan Stanley and Davd Shaw, founder of D.E. Shaw & Co.) Pars tradng reles on the fact that certan securtes, often compettors n the same sector, are correlated n ther day-to-day prce movements When the correlaton broke down,.e. one stock traded up whle the other traded down, they would sell the outperformng stock and buy the underperformng one, bettng that the "spread" between the two would eventually converge Pars tradng strateges CAC and DAQ ndces Pars tradng strateges nclude: Beng long the best stock and short the worst stock n the same ndustry Shortng an ndex and gong long a stock that s expected to outperform the ndex Buyng an ndex and shortng a stock that s a part of the ndex but expected to declne CAC and DAQ ndces Market orders An order s an nstructon from a customer to a broker to buy or sell on the exchange Shares may be traded usng two mechansms for submttng an order to buy or sell These are known as a market order and a lmt order and are also referred to as aggressve and passve trades respectvely A market order s executed mmedately at the best avalable prce The customer has no guarantee regardng the prce Fllng a market order usually nvolves crossng the spread between the bd and ask and the trade prce may dffer sgnfcantly from the last quote f the volume of the order s large 3

4 Lmt orders A lmt order s an order to trade a pre-specfed number of shares at a pre-specfed prce Lmt orders have the advantage of removng the rsk of prce movements as a transacton wll only occur f the prce set by the lmt order, known as the lmt prce, s obtaned. In ths sense, the lmt order s smlar to wrtng an opton to the market or dealer The dsadvantage of a lmt order s that executon s not guaranteed. Furthermore, the tme taken to execute the order, should any transactons take place, depends on the lmt prce, the number of shares and the market condtons In many stuatons, ths uncertanty n executon tme and the opportunty cost of watng can make the lmt order an unattractve mechansm for tradng Market or lmt order The market order s an order to trade a specfc number of shares at the best prce currently avalable Although the market order guarantees that that the transacton wll take place mmedately, t has the dsadvantage of rsk exposure to adverse prce movements Ths rsk ncreases when tradng large numbers of shares n a volatle market A market order may be vewed as a lmt order wth an nfnte lmt prce Traders are requred to select between market orders and lmt orders by attemptng to assess and compare the rsk of mmedate executon of the former mechansm wth the rsk of delayed executon of the latter mechansm VWAP Volume-Weghted Average Prce (VWAP) s the rato of the value traded to total volume traded over a partcular tme horzon (usually one day): V p VWAP = V VWAP measures the average prce a stock traded at over the specfed tradng horzon VWAP s often used as a tradng benchmark by nvestors (such as penson and mutual funds) who am to be as passve as possble durng executon The am of usng a VWAP tradng target s to ensure that the trader executng the order does so n-lne wth volume on the market Ths executon can reduce transacton costs by mnmsng market mpact Market exchanges NASDAQ s an entrely electronc exchange: all orders, whether generated by an algorthm or a person, are sent to NASDAQ va an electronc nterface and order routng system, and all matches between buyers and sellers are executed by computer Electronc Crossng Networks (ECNs) are frms provdng ndependent and competng markets for tradng on the NASDAQ exchange Examples nclude Island ( Market mcrostructure Market mcrostructure refers to the underlyng processes that govern tradng costs, prces, volume, and tradng behavor Ths ncludes prce dscovery and the determnants of lqudty and transactons costs The order book provdes much of the nformaton avalable for market mcrostructure analyss Order books The hghest buy order s for 35,204 shares at $27.21 and the lowest sell order s for 27,408 shares at $27.22 Ths gves a spread of $ $27.21 = $0.01 and a mdspread prce of $

5 Order book snapshot The order book provdes nformaton about ndvdual buy and sell offers, n terms of the volumes that are nvolved n each order, whch are avalable at any nstant n tme The order book snapshot dsplays the volumes assocated wth the bd prce of $27.21 and the ask prce of $27.22 An understandng of how ths order book changes wth tme s mportant for determnng whether the trade prce s lkely to ncrease or decrease Indeed t s the trade prce whch s relevant to the tradng strategy as ths s the prce that s actually obtaned Market mcrostructure data Bd and ask prces and volumes Transactons occur whenever the bd and ask prces match Results n trade prce and volume The spread s the dfference between the bd and ask prce Md-spread prce s defned as p md = ½(p bd + p ask ) Bd/ask prce and spread Trade prce and volume Lmt and market orders Hybrd order strategy Return Effcent fronter * Hybrd? * Lmt * Market Rsk 5

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