Systematic trading

Comprehensive training material for brokers / dealers / arbitrageurs

By:

Manish Jalan
Director, Samssara Capital Technologies LLP (www.samssara.com)

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Overview of the program

 Introduction to the systematic trading strategies

 Building blocks of the systematic trading strategies

 Spread and badla strategies – non-risk / risk

 Using practical mathematics to profit from spread trading

 Details on risk based arbitrage like sector-sector, stock-stock

 Examples of comprehensive and practical systematic trading strategies like pair

trading, trend following, high frequency trading

 Delta hedging and risk management in trading strategies

 Brief overview of automation and algo trading

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The size of systematic trading strategies

 TABB group reported in Aug’2009

– 300 securities and large quant funds
– Recorded $21 billion in profits in 2008!

 Pure high-frequency firms represents

– 2% of the 20,000 trading firms in US
– Account of 67% of all US volumes

 Total AUM of high-frequency trading funds

– $141 billion
– Down 21% from the high
– Compared to global hedge fund shrinking by 33% since 2008

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The changes in trading techniques in Indian market

Present Future
Multi-Exchange / Multi Asset
Cash to Cash Arbitrage / Badla
Co-located Arb

NSE Co-located Cash Future Spread

Cash-Future Arb on NSE / Simple Badla
Arb

Index Arb - Pure Risk-based Index Arb

Pair Trading on Statistical and Advanced

Algos
Pair Trading Technicals
Pair Trading on Baskets

Trend Following on Multi-Statistical

Tend Following – Technicals
Factors

Fundamentals on Equity Research Factor Modelling

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The building blocks

Define End Goal Define Set of Rules

Collect Data Back-test Optimize Simulate

Connect to OMS Connect to Exchange Manage Risk

Improve and Maintain

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Defining the end goal

• Proprietary Trading
• Agency Trading
Nature • Clients Trading (Wealth Management)

• Low
• Medium
Frequency • High

• Higher AUM, Long term return

• Lower AUM, Daily profits
AUM & • Non-correlated fresh strategy / Refine old ones
Strategy

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Defining the set of rules

Experience

Talking to Logical and

traders and business
analysts sense

Simple
Simple
observations in
technical rules
market

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The spread strategies

 Simultaneous buying and selling of assets in 2 different exchanges, expiries,

sectors etc. which are suppose to move in tandem

 Traditionally pure spread strategies like cash-future arbitrage, BSE-NSE

arbitrage, Calendar spreads has done very well

 Now most of the spread strategy game has shifted to NSE co-locations as the
spreads needs to be hit fast

 Hence, in the process – risk based arbitrage strategies are gaining much needed
ground

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The spread / badla

( BestAsk BestBid )
Spread ( BP) 10000
( BestAsk BestBid )
2

Spread (Ticks) BestAsk BestBid

 Pure Spread / Badla Strategies:

• Cash – Future
• Eg: Reliance futures vs Reliance in cash, Nifty futures vs Nifty 50 basket in cash
• Nifty cash future arbitrage – also called index arbitrage
• Calendar spreads – Nifty futures near month / next month / far months
• Options spreads – Buying Nifty call, put and hedging delta with futures

 Risk based spread strategies

• ICICI – HDFC Bank spread, Nifty – Reliance spread, Nifty – Basket spread
• Mitigate risks using mean reversion techniques

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Type of spread strategies

 Cash-Future Arbitrage
• Prevalent with houses having large funds
• Cash-Future Arbitrage (Long Cash / Short Futures) – As they converge on day of expiry
• Rollover of the futures – to continuously benefit from premiums / discount (~ 1% monthly)
• Risk free trade
• Most frequently in stocks which has higher volatility in futures

 Calendar Spreads
• Only span margin required with doing calendar spreads in futures in NSE
• Stocks in Premium – when they goto extra premium – you short far month and buy near month
• Stocks in Premium – when they trade at par – you buy far months and short near month
• FII’s willing to automatically trade even at 0.5% monthly
• Most prevalent from middle of month – when liquidity in next month starts in stocks
• Nifty – always liquidity available

 Dividend Arbitrage
• Stocks trading at premium goes to discount in futures
• Underlying cash delivery is bought by many because of the dividend benefits
• You get tax free dividend – on the delivery stocks and hence the discount Eg: SBIN

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ETF / Other instruments

 Gold ETFs and Gold Futures

• Gold ETF available from various banks with demat numbers – subject to physical arbitrage
• Arbitrage between Gold and Gold mini possible
• Arbitrage between near and next month possible in Gold futures
• Options arbitrage is not possible – as Gold options are not available

 Currency
• Calendar spreads, Dollar arbitrage

 Options Spread Arbitrage

• Options spread – Implied vol arbitrage
• Implied vol – acts as prices in options – and the delta needs to be continuously hedged
• Implied vol can used for spread trading – as long as the delta is continuously hedged
• Single stock options arbitrage like buying call and put options of Suzlon and hedging with stock futures

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Trading Calendar Spreads in Tata Motors
2.5

1.5

0.5

• Calendar spread in Tata Motors between July and August Contract

• Mean spread: Rs. 1.53 and StDev in Spread: Rs. 0.18
• 2 StDev of Spread: Rs. 1.91 and Rs. 1.16 ( StDev = 36 Paisa)
• Total cost on per Lot= Rs 240*4*1000 = Rs. 960,000 (Rs. 144 @ Rs. 1500 Per Cr.)
• Hence total net profit = Rs. 0.36*1000 = Rs. 360 – Rs. 144 = Rs. 216
• Hence on putting the trade, we can make about: Rs. 216 (unleveraged on capital of Rs. 50000 per day)
• Most of these spreads are available only say 10 days in a month – mostly near to the expiry
• Fund deployment is only the span margin and hence the ROI increases on these trades

Excel hands-on exercise for participants on spread trading

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Spread trading in HDFC-ICICI futures

HDFC ICICI
150
140
130
120
110
100
90
01-06-2010 01-07-2010 01-08-2010 01-09-2010 01-10-2010

0.90

0.85

0.80

0.75

0.70

0.65
01-06-2010 01-07-2010 01-08-2010 01-09-2010 01-10-2010

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Why Mathematics & Statistics?

Technical & Statistical

Pure Technical Models
Models

Moderate ROI when model is working Superior ROI when model is working

Large draw-downs when model stops Flattish ROI when model stops

Long stretch of continuous bleeding Shorter stretch of continuous flattish

in returns period

User can diversify and make multi-

User might lose confidence
models

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Mean and Variance

Constant Mean Constant Variance

12 9
8
10
7
8 6
5
6
4
4 3
2
2
1
0 0

Increasing Mean Increasing Variance

40 30
35
25
30
20
25
20 15
15
10
10
5
5
0 0

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Designing profitable trend following system

NIFTY 20MA 50MA 100MA

7000

6000

5000

4000

3000

2000

1000

0
Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10

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Profiting from Bid/Ask and Order books in Currencies – USDINR

VAeq 55.5725 2
f ( Bid , Ask )
VBeq 55.5700 7
VBeq B0 ( B1 )1 2 ( B2 )1 3 ( B3 )1 4 ( B5 )1 5 55.5675 15
55.5650 25
12 13 14 15
VAeq A0 ( A1 ) ( A2 ) ( A3 ) ( A5 )
55.5625 31
55.5600

 Use the order book to identify whether bids are heavy or offers are 42 55.5975
heavy 20 55.5950
 Analyze trades done on bid/offer to identify short term directional
movement 15 55.5925

 Give higher preference to best bid / ask and decay the significance 11 55.5900
down the order book
6 55.5875
 Identify short term directional movement – to benefit from short
term movements in the USDINR currency market

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High frequency example

Short Term Upward

Trades lifted on the Offer Momentum

Trades hitting the Bid

10:00:00 10:00:30 10:01:00 10:01:30

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What is Risk?

 Deviation from possible outcomes

 Fat-tails in the market
 Risks: Systematic and Non-systematic

0.6

0.5

0.4

0.3

0.2

0.1

0
-3 -2 -1 0 1 2 3
-0.1

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Systematic Risks

 Systematic Risks
 We can foresee and prepare for these risks
 Market direction risk, net rupee exposure
 Sector risk
 Single stock risk (E.g.: Satyam)
 Slippage risk
 Execution risk (software crash, power failure etc.)

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Systematic risk mitigation

 In design
• Portfolio hedging and dynamic hedging
• Market direction, net rupee risks / Market direction neutral
• Single sector exposure risks (< y% of the portfolio)
• Single stock exposure (< x% of the portfolio)

 During execution
• Design to take order book (bid and ask) into account
• Caps on daily turnover in the system
• Caps on single trade max rupee value to be executed
• Caps on number of trades in a day
• System should handle power failure and software crash

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The Delta Hedging – Evolution

Type of delta hedging in India The way delta hedge is changing

Mindset in Past: Easy money / No Risk Mindset Today: Taking risks and managing
Returns in delta hedging strategies risks to yield consistent returns

Partial delta hedging – based on volatility of

Pure delta hedging in cash / future arbitrage
the underlying

Managing delta risks using dynamic options

Pure delta hedging in options arbitrage
strategies

Risk based hedge, partial hedge based on

Delta hedging in Index arbitrage
convergence criteria of underlying

Hedging using partial bank futures stocks

Delta hedging in Bank Nifty Index
based on convergence criteria

Delta hedging in Gold ETF / Nifty ETF Opportunity in Pure ETF arbitrage still exists

Trend momentum based strategies to

Delta hedging in Portfolio
occasionally hedge / partial hedge

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Delta hedging in Bank Nifty Options

 Buying options => buying volatility and vice versa

 Options spread => Implied Volatility spread
 Determine the net delta
• Long call / Short put: Long delta
• Short call / Long put: Negative delta
 Bank Nifty Options: Long Call / Long Put (to take the IV spread) then the net delta has
to be neutralized. Hence, 0.5*10 – 0.4*10 = 1 delta. Hence short 1 futures contract.
 The delta hedge can be static / dynamic. For intra-day spread – static delta hedge is
enough at times, as market does not move too much. But for carrying over of the
positions – people like to do end of the day delta hedges to avoid overnight risks.
 Most profit in options spread strategy comes when market has wild swings and volatility
spikes beyond reasonable limits. E.g.: October’ 2008

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Delta Hedging in Nifty Portfolios

7000 NIFTY Hedge

6000

5000
NIFTY Prices

4000

3000

2000

1000

0
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

 Delta - Net rupee exposure in the market – subjected to market direction risk
 Delta hedging is the most popular technique to protect wealth and manage risk
 Identify cycles in the market using trend momentum strategies
 Time period to be decided based on trading position: daily, weekly, monthly etc.
 Using of Nifty futures and options to hedge delta
 Hedging can be all 100% or partial: 50%, 25% etc.

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Recommended referrals

• High-Frequency Trading: A Guide to Algorithmic Strategies and Trading Systems

by Irene Aldridge
Prop trading • Statistical Arbitrage: Algorithmic Trading Insights and Techniques by Andrew
Pole
• The Encyclopedia of Trading Strategies by Jeffrey Owen and Donna McCormick

• Algorithmic Trading and DMA: An introduction to direct access trading strategies

by Barry Johnson
Agency trading • Quantitative Trading: How to Build Your Own Algorithmic Trading Business by
Ernset P. Chan

• Wilmott forum: www.wilmott.com

Web forums • Nuclear Phynance: www.nuclearphynance.com

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About Samssara Capital Technologies LLP
COMPANY BACKGROUND PRODUCTS OFFERED
 Samssara Capital Technologies LLP (“Samssara”) is an  Samssara’s products vary from pair trading (statistical
investment solutions firm focused solely on developing arbitrage), factor models, Nifty Index beating products to very
automated algorithmic and quantitative trading and investment high frequency trading strategies
strategies  samCAP, a key product offered by Samssara, is a factor
 It was launched in 2010 by a team of IIM Ahmedabad and IIT model, where the model identifies a basket of stocks in Nifty
Bombay graduates - Rajesh Baheti, Manish Jalan and that tend to outperform the index and takes a long position in
Kashyap Bhargava these stocks. Alongside, the product also hedges the
 Samssara caters to its clients' needs of providing an investor’s portfolio using Nifty futures – whenever the market
alternative asset management vehicle, with the focus on 100% turns bearish
automated and quantitative trading strategies  Other products offered include samTREND - a trend following
 The team at Samssara works on mathematical models and strategy in equities, commodities & currencies and samWILLS
statistics that identify repetitive patterns in equity, commodity – a long-short strategy based on statistical arbitrage
and currency markets  Samssara also develops in-house products which are used by
 The addressable market for Samssara is global - as the firm investors like HNI’s, corporate treasuries, Prop houses of
can develop and build models which can function in both brokers and investors who wants an alternative vehicle for
developing markets with limited competition and developed investment apart from equities and fixed income.
markets with strong competition  The products are designed to generate consistent returns and
 Samssara’s client base includes the leading international and ride the volatility of the markets with systematic approach
domestic banks, international and domestic stock brokers,  Additionally, Samssara works on providing high end services
family offices, corporate treasuries and HNIs and strategy development consultancy to hedge funds and
International Banks globally

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Contact us

Manish Jalan Tarun Soni

M: +91 98678 32726 M: +91 98692 17190
D: +91 22 6748 7720 D: +91 22 6748 7720
E: [email protected] E: [email protected]

Head Office: Development Office:

208/209, Veena Chambers 207, Business Classic,
21 Dalal Street Behind H P Petrol Pump,
Mumbai – 400 001 Chincholi Bunder Road, Malad (W)
Mumbai – 400 064

For more information do visit : www.samssara.com

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