Quantitative trading consists of trading strategies based on quantitative analysis, which rely on mathematical calculations and number crunching to identify trading opportunities. Quantitative traders take a trading technique and create a model of it using mathematics, and then develop a computer program that applies the model to historical market data. Let's see what quantitative trading is, what it is for, we will see a small example and its advantages and disadvantages.
What is quantitative trading
Quantitative trading consists of trading strategies based on quantitative analysis, which rely on mathematical calculations and number crunching to identify trading opportunities. Price and volume are two of the most common data used in quantitative analysis as primary inputs to mathematical models. Since quantitative trading is typically used by financial institutions and hedge funds, the trades are typically large and can involve the buying and selling of hundreds of thousands of stocks and other securities. However, quantitative trading is increasingly used by individual investors.
What is quantitative trading for?
Quantitative traders take a trading technique and create a model of it using mathematics, and then develop a computer program that applies the model to historical market data. The model is then backtested and optimized. If favorable results are obtained, the system is applied in real-time markets with real capital. The best way to describe how quantitative trading models work is using an analogy. Let's take an example: a weather report in which the meteorologist predicts a 90% chance of rain while the sun is shining. The meteorologist reaches this counterintuitive conclusion by collecting and analyzing climate data from sensors throughout the area. A computerized quantitative analysis reveals specific patterns in the data. When these patterns are compared to the same patterns revealed in historical climate data (backtesting), and 90 out of 100 times the result is rain, then the meteorologist can draw the conclusion with confidence, the 90% forecast. Quantitative traders apply this same process to the financial market to make trading decisions.
What quantitative trading is made up of. Source: WallStreetMojo.
Example of use of quantitative trading
Based on the trader's research and preferences, quantitative trading algorithms can be customized to evaluate different parameters related to a stock. For example, let's imagine a trader who believes in momentum investing. He may choose to write a simple program that picks winners during a bullish momentum in the markets. During the next market rally, the program will buy those shares. This is a fairly simple example of quantitative investing. Typically, a range of parameters, from technical analysis to fundamental analysis to security value, are used to select a complex combination of securities designed to maximize profits. These parameters are programmed into a trading system to take advantage of market movements.
Example of use of quantitative trading. Source: AlgoTrades.com
Advantages and disadvantages of quantitative trading
Overcoming emotions is one of the most widespread problems in trading. Whether it is fear or greed, when trading, emotion only serves to drown out rational thought, which usually leads to losses. Computers and mathematics do not have emotions, so quantitative trading eliminates this problem. Of course, quantitative trading also has its problems. Financial markets are some of the most dynamic entities that exist. Therefore, quantitative trading models must be equally dynamic to be successful. Many quantitative traders develop models that are temporarily profitable for the market conditions for which they were developed, but ultimately fail when market conditions change.