(CONTINUED FROM FRONT FL AP) While Dr. Chan takes the time to outline the essential $60.00 USA / $66.00 CAN Wiley Trading aspects of turning quantitative trading strategies CHAN into profi ts, he doesn’t get into overly theoretical Quantitative Trading Praise for or sophisticated theories. Instead, he highlights the Q By some estimates, quantitative (or algorithmic) simple tools and techniques you can use to gain a trading now accounts for over one-third of “As technology has evolved, so has the ease in developing trading strategies. Ernest Chan does all u much-needed edge over today’s institutional traders. trading volume in the United States. While traders, current and prospective, a real service by succinctly outlining the tremendous benefi ts, but also a institutional traders continue to implement this highly And for those who want to keep up with the some of the pitfalls, in utilizing many of the recently implemented quantitative trading techniques.” Quantitative effective approach, many independent traders—with n latest news, ideas, and trends in quantitative —PETER BORISH, Chairman and CEO, Computer Trading Corporation limited resources and less computing power—have t trading, you’re welcome to visit Dr. Chan’s blog, wondered if they can still challenge powerful industry i epchan.blogspot.com, as well as his premium “Dr. Ernest Chan provides an optimal framework for strategy development, back-testing, risk management, t professionals at their own game? The answer is “yes,” content Web site, epchan.com/subscriptions, programming knowledge, and real-time system implementation to develop and run an algorithmic trading a Trading and in Quantitative Trading, author Dr. Ernest Chan, which you’ll have free access to with purchase of business step by step in Quantitative Trading.” t a respected independent trader and consultant, will this book. —YASER ANWAR, trader i show you how. v e As an independent trader, you’re free from the con- “Quantitative systematic trading is a challenging fi eld that has always been shrouded in mystery, Whether you’re an independent “retail” trader looking straints found in today’s institutional environment— seemingly too diffi cult to master by all but an elite few. In this honest and practical guide, Dr. Chan to start your own quantitative trading business or an T and as long as you adhere to the discipline of highlights the essential cornerstones of a successful automated trading operation and shares lessons he individual who aspires to work as a quantitative r quantitative trading, you can achieve signifi cant learned the hard way while offering clear direction to steer readers away from common traps that both trader at a major fi nancial institution, this practical a returns. With this reliable resource as your guide, individual and institutional traders often succumb to.” guide contains the information you need to succeed. d you’ll quickly discover what it takes to make it in such —ROSARIO M. INGARGIOLA, CTO, Alphacet, Inc. a dynamic and demanding fi eld. i Organized around the steps you should take to start n “This book provides valuable insight into how private investors can establish a solid structure for success trading quantitatively, this book skillfully addresses ERNEST P. CHAN, PHD, is a quantitative in algorithmic trading. Ernie’s extensive hands-on experience in building trading systems is invaluable for g how to: aspiring traders who wish to take their knowledge to the next level.” trader and consultant who advises clients on how (cid:127) Find a viable trading strategy that you’re both comfortable to implement automated statistical trading strategies. —RAMON CUMMINS, private investor AH How to Build Your Own Algorithmic Trading Business with and confident in He has worked as a quantitative researcher and lgoow (cid:127) Backtest your strategy—with MATLAB®, Excel, and other trader in various investment banks including Morgan “Out of the many books and articles on quantitative trading that I’ve read over the years, very few have rith to platforms—to ensure good historical performance Stanley and Credit Suisse, as well as hedge funds been of much use at all. In most instances, the authors have no real knowledge of the subject matter, or do mB such as Mapleridge Capital, Millennium Partners, have something important to say but are unwilling to do so because of fears of having trade secrets stolen. ic Tuild (cid:127) Bexueilcdu taen dy oiumrp sltermateengty an automated trading system to and MANE Fund Management. Dr. Chan earned a Ernie subscribes to a different credo: Share meaningful information and have meaningful interactions rad Yo (cid:127) Scale up or wind down your strategies depending on their PhD in physics from Cornell University. with the quantitative community at large. Ernie successfully distills a large amount of detailed and diffi cult ingur O real-world profitability subject matter down to a very clear and comprehensive resource for novice and pro alike.” JACKET DESIGN: PAUL McCARTHY Buw (cid:127) Manage the money and risks involved in holding positions JACKET ART: © DON RELYEA —STEVE HALPERN, founder, HCC Capital, LLC sinn generated by your strategy e s (cid:127) Incorporate advanced concepts that most professionals use s into your everyday trading activities (cid:127) And much more E R N E S T P. C H A N (CONTINUED ON BACK FL AP) P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome ii P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome Quantitative Trading i P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome Founded in 1807, John Wiley & Sons is the oldest independent publish- ingcompanyintheUnitedStates.WithofficesinNorthAmerica,Europe, Australia,andAsia,Wileyisgloballycommittedtodevelopingandmarket- ing print and electronic products and services for our customers’ profes- sionalandpersonalknowledgeandunderstanding. TheWileyTradingseriesfeaturesbooksbytraderswhohavesurvived 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 theadviceandstrategiesneededtoprospertodayandwellintothefuture. Foralistofavailabletitles,visitourWebsiteatwww.WileyFinance.com. ii P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome Quantitative Trading How to Build Your Own Algorithmic Trading Business ERNEST P. CHAN JohnWiley&Sons,Inc. iii P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome Copyright(cid:1)C 2009byErnestP.Chan.Allrightsreserved. PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey. PublishedsimultaneouslyinCanada. Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedin anyformorbyanymeans,electronic,mechanical,photocopying,recording,scanning,oroth- erwise,exceptaspermittedunderSection107or108ofthe1976UnitedStatesCopyrightAct, withouteitherthepriorwrittenpermissionofthePublisher,orauthorizationthroughpayment oftheappropriateper-copyfeetotheCopyrightClearanceCenter,Inc.,222RosewoodDrive, Danvers,MA01923,(978)750-8400,fax(978)646-8600,oronthewebatwww.copyright.com. RequeststothePublisherforpermissionshouldbeaddressedtothePermissionsDepartment, JohnWiley&Sons,Inc.,111RiverStreet,Hoboken,NJ07030,(201)748-6011,fax(201)748- 6008,oronlineathttp://www.wiley.com/go/permissions. LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheirbest effortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespecttothe accuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimanyimplied warrantiesofmerchantabilityorfitnessforaparticularpurpose.Nowarrantymaybecreated orextendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategiescon- tainedhereinmaynotbesuitableforyoursituation.Youshouldconsultwithaprofessional whereappropriate.Neitherthepublishernorauthorshallbeliableforanylossofprofitorany othercommercialdamages,includingbutnotlimitedtospecial,incidental,consequential,or otherdamages. Forgeneralinformationonourotherproductsandservicesorfortechnicalsupport,please contactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974,outsidethe UnitedStatesat(317)572-3993orfax(317)572-4002. Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappears inprintmaynotbeavailableinelectronicbooks.FormoreinformationaboutWileyproducts, visitourwebsiteatwww.wiley.com. LibraryofCongressCataloging-in-PublicationData Chan,ErnestP. Quantitativetrading:howtobuildyourownalgorithmictradingbusiness/ErnestP.Chan. p.cm.–(Wileytradingseries) Includesbibliographicalreferencesandindex. ISBN978-0-470-28488-9(cloth) 1.Investmentanalysis. 2.Stocks. 3.Stockbrokers. I.Title. HG4529.C445 2009 332.64–dc22 2008020125 PrintedintheUnitedStatesofAmerica. 10 9 8 7 6 5 4 3 2 1 iv P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome To my parents Hung Yip and Ching, and to Ben. v P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome vi P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome Contents Preface xi Acknowledgments xvii CHAPTER 1 The Whats, Whos, and Whys of Quantitative Trading 1 WhoCanBecomeaQuantitativeTrader? 2 TheBusinessCaseforQuantitativeTrading 4 Scalability 5 DemandonTime 5 TheNonnecessityofMarketing 7 TheWayForward 8 CHAPTER 2 Fishing for Ideas 9 HowtoIdentifyaStrategyThatSuitsYou 12 YourWorkingHours 12 YourProgrammingSkills 13 YourTradingCapital 13 YourGoal 16 ATasteforPlausibleStrategiesandTheirPitfalls 17 HowDoesItComparewithaBenchmarkandHowConsistent AreItsReturns? 18 HowDeepandLongIstheDrawdown? 21 HowWillTransactionCostsAffecttheStrategy? 22 DoestheDataSufferfromSurvivorshipBias? 24 HowDidthePerformanceoftheStrategyChangeovertheYears? 24 vii P1:JYS fm JWBK321-Chan September24,2008 13:43 Printer:Yettocome viii CONTENTS DoestheStrategySufferfromData-SnoopingBias? 25 DoestheStrategy“FlyundertheRadar"ofInstitutional MoneyManagers? 27 Summary 28 CHAPTER 3 Backtesting 31 CommonBacktestingPlatforms 32 Excel 32 MATLAB 32 TradeStation 35 High-EndBacktestingPlatforms 35 FindingandUsingHistoricalDatabases 36 AretheDataSplitandDividendAdjusted? 36 AretheDataSurvivorshipBiasFree? 40 DoesYourStrategyUseHighandLowData? 42 PerformanceMeasurement 43 CommonBacktestingPitfallstoAvoid 50 Look-AheadBias 51 Data-SnoopingBias 52 TransactionCosts 60 StrategyRefinement 65 Summary 66 CHAPTER 4 Setting Up Your Business 69 BusinessStructure:RetailorProprietary? 69 ChoosingaBrokerageorProprietaryTradingFirm 71 PhysicalInfrastructure 75 Summary 77 CHAPTER 5 Execution Systems 79 WhatanAutomatedTradingSystemCanDoforYou 79 BuildingaSemiautomatedTradingSystem 81 BuildingaFullyAutomatedTradingSystem 84 MinimizingTransactionCosts 87