Advanced Trading Algorithms from ISB(India School of Business)

Advanced Trading Algorithms

This blog post summarizes the content of a course on advanced trading algorithms, covering four distinct strategies: Accruals, Betting Against Beta, Momentum, G-Score, and an additional segment on Momentum Crashes. Each strategy is broken down into individual lectures, summarizing the key concepts and insights discussed.

Strategy 1: Accruals

Introduction

The Accruals strategy exploits the market's tendency to misprice stocks based on the accrual component of earnings. Accruals represent the portion of earnings not yet realized in cash, which can be manipulated by companies to inflate their reported earnings. This strategy identifies companies with high accruals and shorts them, while longing companies with low accruals, expecting the market to eventually correct the mispricing.

01 Accruals-Introduction

This lecture introduces the concept of accruals and their potential for manipulation by businesses to artificially inflate earnings.

Main Content

• Accrual Accounting: Accrual accounting recognizes revenue when a transaction occurs, even if cash is received later. This creates a potential for default risk and earnings manipulation.
• Earnings Manipulation: Managers under pressure to show high earnings may use accruals to window dress their accounts. For example, they might dump products onto distributors at the end of a period to boost sales, even if the distributor may not be able to sell the products.
• Market Inefficiency: The market often fails to distinguish between earnings driven by cash and those driven by accruals in the short term. This creates an opportunity for traders to exploit this mispricing.

Key Takeaways

• Accruals represent the non-cash component of earnings.
• Managers can manipulate accruals to inflate earnings.
• The market often fails to recognize this manipulation in the short term, creating a trading opportunity.

02 Accruals-Calculation

This lecture delves into the formula used to calculate the accrual component of a company's earnings.

Main Content

The accrual component is calculated as follows:

Accruals = ΔCurrent Assets (excluding cash) - ΔCurrent Liabilities (excluding short-term debt for financing and tax payable) - Depreciation

• ΔCurrent Assets (excluding cash): Represents the change in accruals due to sales recorded but not yet collected in cash.
• ΔCurrent Liabilities (excluding short-term debt for financing and tax payable): Represents the reduction in accruals due to purchases made on credit, excluding debt not related to operations.
• Depreciation: A non-cash expense that needs to be subtracted to arrive at the true accrual component.

Key Takeaways

• The accrual component of earnings can be calculated using readily available financial statement data.
• This formula isolates the change in operating income caused by accruals.

03 Accruals-Ratios

This lecture explains how to calculate the accrual and cash ratios, which are used to identify companies with high and low accruals.

Main Content

• Income from Continuing Operations: The starting point for calculating accrual and cash ratios, it focuses on sustainable earnings from core operations.
• Normalization: Both accrual and cash components are normalized by dividing them by average total assets to allow for comparison between companies of different sizes.
• Accrual Ratio: Accrual component divided by average total assets.
• Cash Ratio: (Income from continuing operations - Accrual component) divided by average total assets.

Key Takeaways

• Accrual and cash ratios provide standardized measures of accrual and cash components of earnings.
• These ratios allow for comparisons across companies of different sizes.

04 Accruals-Strategy

This lecture outlines the complete Accruals trading strategy.

Main Content

1. Compute accrual ratios: Calculate the accrual ratio for each company in your universe.
2. Rank companies: Rank companies based on their accrual ratios, from highest to lowest.
3. Categorize into deciles: Divide the ranked companies into ten groups (deciles).
4. Short high accrual companies: Short companies in the highest decile (highest accrual ratios).
5. Long low accrual companies: Long companies in the lowest decile (lowest accrual ratios).
6. Hold for a period: Hold the long-short portfolio for a predetermined period (e.g., one year).

Key Takeaways

• The Accruals strategy involves shorting companies with high accruals and longing companies with low accruals.
• This strategy exploits the market's tendency to overvalue companies with high accruals, expecting the mispricing to correct over time.

Strategy 2: Betting Against Beta

Introduction

The Betting Against Beta (BAB) strategy exploits the tendency of high-beta stocks to be overpriced by leveraged investors. These investors bid up the prices of high-beta assets, seeking higher returns, but ultimately leading to lower risk-adjusted returns (alpha). The BAB strategy involves shorting high-beta stocks and longing leveraged low-beta assets, aiming to capture the alpha generated by the mispricing.

01 Betting-Against-Beta-Introduction

This lecture introduces the concept of beta, a measure of a stock's volatility relative to the market, and sets the stage for the BAB strategy.

Main Content

• Beta: Beta measures a stock's sensitivity to systematic risk (market risk). A beta of 1 indicates that the stock moves in line with the market, while a beta greater than 1 indicates higher volatility and vice versa.
• Systematic vs. Idiosyncratic Risk: Systematic risk affects the entire market, while idiosyncratic risk is specific to individual companies or sectors. Diversified investors are primarily concerned with systematic risk.
• High Beta vs. Low Beta Stocks: High beta stocks are typically considered aggressive or growth stocks, while low beta stocks are considered defensive stocks (e.g., utilities).
• Constrained Investors: Leveraged investors facing constraints bid up high-beta assets, seeking higher returns, leading to their overvaluation.

Key Takeaways

• Beta measures a stock's volatility relative to the market.
• High-beta stocks tend to be overpriced by constrained investors.
• The BAB strategy exploits this mispricing by shorting high-beta stocks and longing leveraged low-beta assets.

02 Betting-Against-Beta-Capm

This lecture explains the Capital Asset Pricing Model (CAPM), a framework for understanding expected returns based on beta and market risk premium.

Main Content

CAPM Formula: The CAPM calculates the expected return of a stock as follows:

Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

• Risk-Free Rate: The return an investor can expect from a risk-free investment, such as a government bond.
• Market Return: The expected return of the overall market.
• Market Risk Premium: The difference between the market return and the risk-free rate.
• Alpha: The difference between the actual return of a stock and its expected return based on CAPM.

Key Takeaways

• CAPM provides a theoretical framework for understanding expected returns based on beta.
• Alpha represents the excess return a stock generates above its expected return based on CAPM.

03 Betting-Against-Beta-Strategy

This lecture details the BAB trading strategy.

Main Content

1. Obtain Betas: Gather beta values for the stocks in your universe.
2. Sort Companies: Rank companies based on their betas.
3. Divide into Above/Below Median: Separate companies into two groups: above median beta and below median beta.
4. Short High Beta Stocks: Short stocks in the above median beta group.
5. Long Low Beta Stocks: Long stocks in the below median beta group.
6. Hold for a Period: Hold the long-short portfolio for a predetermined period (e.g., one month).

Implementation Details

• Beta Calculation: Use publicly available betas, eliminating the need for manual calculation.
• Trading Window: Execute the strategy at the beginning of your desired trading period (e.g., first day of the month).
• Rolling Window: Recalculate betas and adjust the portfolio monthly using a rolling six-month window to account for changes in beta.

Key Takeaways

• The BAB strategy involves shorting high-beta stocks and longing leveraged low-beta assets.
• This strategy exploits the overvaluation of high-beta stocks, aiming to capture the alpha generated by the mispricing.
• A rolling window approach is used to adjust the portfolio for changes in beta over time.

Strategy 3: Momentum

Introduction

The Momentum strategy capitalizes on the tendency of stocks with strong past performance to continue outperforming, while stocks with weak past performance continue underperforming. This strategy identifies past winners and losers based on their historical returns and constructs a long-short portfolio by longing the winners and shorting the losers.

01 Momentum-Introduction

This lecture defines momentum in the context of financial markets and highlights its contradiction to the Efficient Market Hypothesis.

Main Content

• Momentum: The tendency of rising stock prices to continue rising and falling stock prices to continue falling.
• Market Anomaly: Momentum contradicts the Efficient Market Hypothesis, which suggests that all available information is already reflected in stock prices.
• Empirical Evidence: Extensive research shows that momentum works across various asset classes, markets, and stock sizes.

Key Takeaways

• Momentum refers to the persistence of past stock price trends.
• It represents a market anomaly, contradicting the Efficient Market Hypothesis.

02 Momentum-Lookback-Period

This lecture explores the significance of the lookback period in momentum strategies and introduces different types of momentum based on its duration.

Main Content

• Lookback Period: The timeframe used to measure a stock's past performance (e.g., 12 months).
• Types of Momentum:
  • Short-term Momentum: Lookback period of one month or less, often leading to return reversals.
  • Long-term Momentum: Lookback period of 3-5 years, also associated with return reversals.
  • Intermediate-term Momentum: Lookback period of 6-12 months, showing trend continuation rather than reversals.

Key Takeaways

• Different lookback periods lead to different types of momentum.
• Intermediate-term momentum, the focus of this strategy, exhibits trend continuation.

03 Momentum-Strategy

This lecture outlines the detailed Momentum trading strategy.

Main Content

1. Data Preparation: Collect stock price data for the last 12 months (lookback period) for liquid stocks. Calculate daily and monthly returns.
2. Calculate Modified Momentum: Calculate the cumulative 12-month returns, excluding the last month's returns, to mitigate short-term momentum effects.
3. Create Winner and Loser Portfolios: Rank stocks based on their modified momentum. Divide into deciles and construct equally weighted portfolios: the highest decile representing the "winner" portfolio and the lowest decile representing the "loser" portfolio.
4. Trading: Long the winner portfolio and short the loser portfolio (pure momentum portfolio). Alternatively, long the winner portfolio without shorting (risky due to market exposure).
5. Holding Period: Hold the portfolio for a predetermined period, typically 3 months, to capture the abnormal returns before they dissipate.

Key Takeaways

• The Momentum strategy involves longing stocks with strong past performance and shorting those with weak past performance.
• A modified momentum calculation is used to mitigate short-term momentum effects.
• The holding period is typically limited to capture the abnormal returns before they reverse.

04 Momentum-Returns

This lecture discusses the returns generated by the Momentum strategy in the Indian market and introduces further research developments.

Main Content

• Indian Market Returns: Using a 12-month lookback period and varying holding periods, the Momentum strategy generated average effective annual returns ranging from 15.19% to 16.92% in the Indian market for 2016.
• Experimentation: Different lookback periods may yield different results, encouraging backtesting and experimentation to find the optimal strategy.
• Time-Series vs. Cross-Sectional Momentum:
  • Time-Series Momentum: Also known as absolute momentum, it measures a stock's performance based on its own historical returns.
  • Cross-Sectional Momentum: Also known as relative strength momentum, it measures a stock's performance relative to other stocks.

Key Takeaways

• The Momentum strategy has shown positive returns in the Indian market.
• Different lookback periods can yield varying results, necessitating experimentation.
• Time-series and cross-sectional momentum provide different perspectives for identifying winners and losers.

Strategy 4: Momentum Crashes

Introduction

The Momentum Crashes strategy addresses a significant weakness of the traditional Momentum strategy: its vulnerability to sudden market crashes and subsequent rebounds. During such events, stocks that have experienced significant declines can rebound sharply, causing substantial losses for momentum portfolios. This strategy incorporates put options to protect against such crashes.

01 Momentum-Crashes-Introduction

This lecture explains the concept of momentum crashes and highlights the situations where the traditional Momentum strategy can fail.

Main Content

• Momentum Crash: Occurs when stocks that have experienced significant declines rebound sharply, leading to losses for momentum portfolios.
• Market Conditions for Crashes: Momentum crashes are more likely to occur during:
  • Panic states
  • Market declines followed by sudden rebounds (V-shaped recoveries)
  • High market volatility

Key Takeaways

• The traditional Momentum strategy is vulnerable to sudden market crashes.
• Specific market conditions can signal an increased risk of momentum crashes.

02 Momentum-Crashes-Options-Primer- (Buyer's Perspective)

This lecture provides a primer on options, focusing on call and put options from a buyer's perspective.

Main Content

• Options: Contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price (strike price) on or before a specific date (expiration date).
• Call Option: Gives the holder the right to buy the underlying asset.
• Put Option: Gives the holder the right to sell the underlying asset.
• Premium: The price paid for the option.
• Payoff Diagrams: The lecture explains how to construct payoff diagrams for call and put options, illustrating the potential profits and losses for the buyer.

Key Takeaways

• Call options provide the right to buy, while put options provide the right to sell.
• Option buyers pay a premium for the right to exercise their option.
• Payoff diagrams help visualize the potential profits and losses associated with options.

03 Momentum-Crashes-Options-Primer- (Seller's Perspective)

This lecture complements the previous one by explaining options from a seller's perspective.

Main Content

• Option Seller: The counterparty to the option buyer, obligated to fulfill the buyer's right to buy or sell the underlying asset if the option is exercised.
• Payoff for Sellers:
  • Call Option Seller: Receives the premium upfront but faces unlimited potential losses if the stock price rises significantly.
  • Put Option Seller: Receives the premium upfront but faces limited potential losses (up to the strike price) if the stock price falls.

Key Takeaways

• Option sellers receive the premium but face potential obligations if the option is exercised.
• Call option sellers have unlimited potential losses, while put option sellers have limited potential losses.

04 Momentum-Crashes-Abstract

This lecture summarizes the key insights from the paper "Momentum Crashes" by Daniel and Moskowitz.

Main Content

• Momentum Crash Predictability: While momentum strategies generate positive average returns, they experience infrequent but persistent negative returns during momentum crashes. These crashes are partly forecastable based on market conditions.
• Ex-Ante vs. Ex-Post: Understanding market conditions before a crash (ex-ante) is crucial for avoiding losses, while analyzing them after a crash (ex-post) is only useful for learning.
• Characteristics of Momentum Crashes:
  • Occur during panic states
  • Follow market declines and high volatility
  • Coincide with market rebounds

Key Takeaways

• Momentum crashes are partly forecastable based on specific market characteristics.
• Panic states, market declines, high volatility, and market rebounds are warning signs for potential momentum crashes.

05 Momentum-Crashes-Strategy

This lecture presents a modified Momentum strategy incorporating put options to mitigate losses during momentum crashes.

Main Content

• Traditional Momentum Strategy: Long winners and short losers.
• Modified Strategy: Long winners and buy put options on the losers instead of shorting them.
• Rationale: Put options provide downside protection against a sharp rebound in the prices of loser stocks, limiting potential losses during a momentum crash.
• Cost of Protection: Buying put options involves paying a premium, reducing the overall returns of the strategy if a crash does not occur.
• Trade-off: The modified strategy offers protection against momentum crashes but comes at the cost of lower returns in normal market conditions.

Key Takeaways

• Incorporating put options on loser stocks can protect against momentum crashes.
• This protection comes at the cost of reduced returns in normal market conditions.