By some estimates, quantitative or algorithmic trading now accounts for over 80 percent of the equity trading volume (Economist, 2019). There are, of course, innumerable books on the advanced mathematics and strategies utilized by institutional traders in this arena. However, can an independent, retail trader benefit from these algorithms? Can an individual with limited resources and computing power backtest and execute strategies over thousands of stocks, and come to challenge the powerful industry participants at their own game?

I will show you how this can, in fact, be achieved.

WHO IS THIS BOOK FOR?

I wrote this book with two types of readers in mind:

1. Aspiring independent (“retail”) traders who are looking to start a quantitative trading business.
2. Students of finance or other technical disciplines (at the undergraduate or MBA level) who aspire to become quantitative traders and portfolio managers at major institutions.

Can these two very different groups of readers benefit from the same set of knowledge and skills? Is there anything common between managing a $100 million portfolio and managing a $100,000 portfolio? My contention is that it is much more logical and sensible for someone to become a profitable $100,000 trader before becoming a profitable $100 million trader. This can be shown to be true on many fronts.

Many legendary quantitative hedge fund managers such as Dr. Edward Thorp of the former Princeton-Newport Partners (Poundstone, 2005) and Dr. Jim Simons of Renaissance Technologies Corp. (Lux, 2000) started their careers trading their own money. They did not begin as portfolio managers for investment banks and hedge funds before starting their own fund management business. Of course, there are also plenty of counterexamples, but clearly this is a possible route to riches as well as intellectual accomplishment, and for someone with an entrepreneurial bent, a preferred route.

Even if your goal is to become an institutional trader, it is still worthwhile to start your own trading business as a first step. Physicists and mathematicians are now swarming Wall Street. Few people on the Street are impressed by a mere PhD from a prestigious university anymore. What is the surest way to get through the door of the top banks and funds? To show that you have a systematic way to profits—in other words, a track record. Quite apart from serving as a stepping stone to a lucrative career in big institutions, having a profitable track record as an independent trader is an invaluable experience in itself. The experience forces you to focus on simple but profitable strategies, and not get sidetracked by overly theoretical or sophisticated theories. It also forces you to focus on the nitty-gritty of quantitative trading that you won't learn from most books: things such as how to build an order entry system that doesn't cost $10,000 of programming resources. Most importantly, it forces you to focus on risk management—after all, your own personal bankruptcy is a possibility here. Finally, having been an institutional as well as a retail quantitative trader and strategist at different times, I only wish that I had read a similar book before I started my career at a bank—I would have achieved profitability many years sooner.

Given these preambles, I won't make any further apologies in the rest of the book in focusing on the entrepreneurial, independent traders and how they can build a quantitative trading business on their own, while hoping that many of the lessons would be useful on their way to institutional money management as well.

WHAT KIND OF BACKGROUND DO YOU NEED?

Despite the scary-sounding title, you don't need to be a math or computer whiz in order to use this book as a guide to start trading quantitatively. Yes, you do need to possess some basic knowledge of statistics, such as how to calculate averages, standard deviations, or how to fit a straight line through a set of data points. Yes, you also need to have some basic familiarity with Excel. But what you don't need is any advanced knowledge of stochastic calculus, neural networks, or other impressive-sounding techniques.

Though it is true that you can make millions with nothing more than Excel, it is also true that there are tools that, if you are proficient with them, will enable you to backtest trading strategies much more efficiently, and may also allow you to retrieve and process data much more easily than you otherwise can. Best among these tools are MATLAB, Python, and R, and they are the most common research platforms that many institutional quantitative strategists and portfolio managers use. Therefore, I will demonstrate how to backtest the majority of strategies using all three languages. In fact, I have included a brief tutorial in the appendix on how to do some basic programming in MATLAB, which is my favorite among the three. For a tutorial on how to use R for finance, I recommend Regenstein (2018). For Python, I like the book by the inventor of its Pandas package, McKinney (2017). MATLAB for home use costs about as much as Microsoft Office, while Python and R are free.

WHAT WILL YOU FIND IN THIS BOOK?

This book is definitely not designed as an encyclopedia of quantitative trading techniques or terminologies. It will not even be about specific profitable strategies (although you can refine the few example strategies embedded here to make them quite profitable). Instead, this is a book that teaches you how to find a profitable strategy yourself. It teaches you the characteristics of a good strategy, how to refine and backtest a strategy to ensure that it has good historical performance, and, more importantly, to ensure that it will remain profitable in the future. It teaches you a systematic way to scale up or wind down your strategies depending on their real-life profitability. It teaches you some of the nuts and bolts of implementing an automated execution system in your own home. Finally, it teaches you some basics of risk management, which is critical if you want to survive over the long term, and also some psychological pitfalls to avoid if you want an enjoyable (and not just profitable) life as a trader.

Even though the basic techniques for finding a good strategy should work for any tradable securities, I have focused my examples on an area of trading I personally know best: statistical arbitrage trading in stocks. While I discuss sources of historical data on stocks, futures, and foreign currencies in the chapter on backtesting, I did not include options because those are quite complicated to backtest for someone new to algorithmic trading. If you are really keen on learning that, please read Chan (2017).

The book is organized roughly in the order of the steps that traders need to undertake to set up their quantitative trading business. These steps begin at finding a viable trading strategy (Chapter 2), then backtesting the strategy to ensure that it at least has good historical performance (Chapter 3), setting up the business and technological infrastructure (Chapter 4), building an automated trading system to execute your strategy (Chapter 5), and managing the money and risks involved in holding positions generated by this strategy (Chapter 6). I will then describe in Chapter 7 a number of important advanced concepts with which most professional quantitative traders are familiar, and finally conclude in Chapter 8 with reflections on how independent traders can find their niche and how they can grow their business. I have also included an appendix that contains a tutorial on using MATLAB.

You'll see two different types of boxed material in this book:

• Sidebars containing an elaboration or illustration of a concept
• Examples, accompanied by Excel (for some), MATLAB, Python, and R codes (for all)

Readers who want to learn more and keep up to date with the latest news, ideas, and trends in quantitative trading are welcome to visit my blog predictnow.ai/blog, where I will do my best to answer their questions. You will find that the website contains articles and presentations of many aspects of quantitative trading. Readers of this book will have free access to the software codes contained in this book located at epchan.com/book and will find the password in a later chapter to enter that website.

—Ernest P. Chan
October 2020

REFERENCES

1. Economist . 2019. “March of the Machines. The stockmarket is now run by computers, algorithms, and passive managers.” October 5. www.economist.com/briefing/2019/10/05/the-stockmarket-is-now-run-by-computers-algorithms-and-passive-managers.
2. Lux, Hal. 2000. “The Secret World of Jim Simons.” Institutional Investor Magazine, November 1.
3. Poundstone, William. 2005. Fortune's Formula. New York: Hill and Wang.