Trading Algorithms

Module 1: Introduction to Trading Strategies and Benchmarks

Disclaimer

This course is for educational purposes and does not guarantee profits from trading. Trading strategies based on past events may not be profitable in the future due to changing market conditions.

Key takeaways:

• Trading strategies are based on past events and may not always be profitable.
• It is important to understand your risk appetite and the potential for losses before trading.
• Investors should be informed of the risks and potential for losses associated with any trading strategy.
• This course is for educational purposes and does not guarantee profits from trading.

Introduction to Trading Strategies

This video introduces the concept of market efficiency and how to create a trading strategy based on academic research.

Introduction:

• This module focuses on trading strategies based on academic research.
• The concept of market efficiency is central to understanding trading strategies.

Main content:

• Market Efficiency: Market efficiency refers to how quickly information is incorporated into stock prices. The debate is about whether this process is instantaneous or takes time.
  • Strong form efficiency: All information, public and private, is reflected in stock prices.
  • Semi-strong form efficiency: All publicly available information is reflected in stock prices.
  • Weak form efficiency: All past information is reflected in stock prices.
• If markets were truly efficient, active investing would be futile. Empirical evidence suggests that markets are not completely efficient, leaving room for active strategies.
• Trading strategies based on academic research: These strategies are based on rigorous research and have an economic rationale.
• Data mining: Data mining involves testing numerous strategies on past data to find patterns that may not be replicable in the future. Trading strategies based on academic research are not pure data mining exercises.
• Importance of understanding market efficiency: Market efficiency serves as a warning that making money in the market is not easy and that any successful trading strategy must have a sound economic rationale.

Key takeaways:

• Market efficiency is the degree to which information is incorporated into stock prices.
• Trading strategies based on academic research have a stronger economic foundation than those derived from data mining.
• Understanding market efficiency helps develop robust trading strategies.

How to Read an Academic Paper (A, B, C)

This series of videos explains how to read an academic paper and identify the sections relevant for developing a trading strategy.

Introduction:

• Academic papers are the source of trading ideas for this course.
• These papers are written for a scholarly audience and can be highly technical.
• This module will guide you on how to extract the essential information for trading strategy development.

Main content:

• Structure of an academic paper:
  • Abstract: Summarizes the entire paper in a concise manner.
  • Introduction: Provides motivation, background, and key findings of the research.
  • Institutional background: Describes the institutional setting of the market being studied.
  • Data sources: Explains the data used in the research and its availability.
  • Trading algorithm: Details the specific formula used for the trading strategy. This is the most crucial section for traders.
  • Hypothesis: Discusses the economic rationale behind the trading strategy.
  • Empirical strategy: Outlines the statistical methods used to test the hypothesis.
  • Results: Presents the performance of the strategy and robustness checks.
  • Conclusion: Summarizes the findings and suggests future research directions.
  • Theory (optional): Elaborates on the theoretical framework underlying the research.
• Key sections for traders:
  • Abstract: Provides a brief overview of the trading strategy.
  • Introduction: Helps understand the motivation and potential of the strategy.
  • Data sources: Confirms data availability for replicating the strategy.
  • Trading algorithm: Describes the formula and data inputs for implementing the strategy.
  • Results: Shows the historical performance of the strategy.
• Tips for reading academic papers:
  • Focus on understanding the trading algorithm and the economic rationale behind it.
  • Ignore highly technical sections like empirical strategy and theory unless you have a strong background in those areas.
  • Read the data section carefully to ensure data availability for replication.
  • When reading the results section, pay attention to the robustness checks to assess the reliability of the strategy.

Key takeaways:

• Understanding the structure of an academic paper can help you extract the essential information for trading.
• Focus on the trading algorithm, data sources, and results sections for practical implementation.
• Use the abstract and introduction to gain an overview of the strategy's potential.

How to Read an Academic Paper: Abstract

This video focuses on reading and understanding the abstract of an academic paper, using Piotroski's paper on value investing as an example.

Introduction:

• The abstract summarizes the key aspects of the research paper in a concise manner.
• Understanding the abstract provides a preliminary understanding of the trading strategy.

Main content:

• Piotroski's paper abstract:
  • The paper investigates a simple accounting-based fundamental analysis strategy for value investing.
  • The strategy focuses on high book-to-market (BM) firms, which are typically undervalued by the market.
  • The paper introduces the F-Score, a formula based on nine accounting variables, to identify financially strong high BM firms.
  • By selecting financially strong high BM firms, investors can potentially increase their returns by at least 7.5% annually compared to a strategy of buying all high BM firms.
  • A long-short strategy that buys expected winners and shorts expected losers based on the F-Score generates a 33% annualized return between 1976 and 1996.
  • The strategy's superior performance is attributed to its focus on small and medium-sized firms, companies with low share turnover, and firms with limited analyst following.
  • The paper argues that the market underreacts to historical financial information, creating opportunities for fundamental analysis.

Key takeaways:

• The abstract provides a concise overview of the trading strategy, including its focus, methodology, and potential returns.
• It highlights the importance of selecting financially strong companies within the universe of high BM firms.
• The abstract suggests that the market's inefficiency in incorporating historical financial information creates opportunities for profitable trading.

Module 3: Trading Strategy 1 - F-Score

Piotroski F-Score Strategy (A, B, C)

These videos explain the construction and economic intuition behind the Piotroski F-Score, a value investing strategy.

Introduction:

• The Piotroski F-Score is a formula for identifying financially strong firms within the universe of high book-to-market (BM) stocks.
• The score is based on nine accounting variables that reflect a company's profitability, capital structure, and operating efficiency.

Main content:

• Components of the F-Score:
  • Profitability measures (4 variables):
    • ROA (Return on Assets): Net income divided by total assets.
    • CFO (Cash Flow from Operations): Cash flow from operating activities divided by total assets.
    • Delta ROA (Change in ROA): Current year ROA minus previous year ROA.
    • Accrual: ROA minus CFO.
  • Capital structure measures (3 variables):
    • Delta Leverage (Change in Leverage): Current year long-term debt divided by total assets minus previous year's ratio.
    • Delta Liquid (Change in Liquidity): Current year current ratio (current assets divided by current liabilities) minus previous year's ratio.
    • EQ_OFFER (Equity Offering): Binary variable; 1 if the firm has not issued equity in the past year, 0 otherwise.
  • Operating efficiency measures (2 variables):
    • Delta Margin (Change in Profit Margin): Current year gross profit margin minus previous year's margin.
    • Delta Turnover (Change in Asset Turnover): Current year asset turnover ratio (sales divided by total assets) minus previous year's ratio.
• Scoring system:
  • Each variable is assigned a score of 1 if it meets a specific criterion (e.g., positive ROA, increasing CFO) and 0 otherwise.
  • The F-Score is the sum of the scores for all nine variables, ranging from 0 to 9.
• Economic intuition:
  • Profitability: High and increasing profitability indicate a healthy business.
  • Cash flow: Strong cash flow from operations suggests sustainable earnings and financial strength.
  • Low accruals: Lower accruals are preferred as they imply less reliance on non-cash earnings and reduce the risk of earnings manipulation.
  • Decreasing leverage: Reducing debt levels signal financial prudence, especially for distressed firms.
  • Increasing liquidity: A higher current ratio suggests improved short-term liquidity and a lower risk of bankruptcy.
  • No equity issuance: Avoiding equity offerings indicates that the company is not relying on dilutive financing, which can be a negative signal for distressed firms.
  • Improving margins and turnover: Increasing profit margins and asset turnover reflect operational efficiency and the company's ability to generate higher returns from its assets.

Key takeaways:

• The Piotroski F-Score is a comprehensive measure of financial strength based on nine accounting variables.
• Higher F-Scores indicate companies with stronger fundamentals and a higher likelihood of future success.
• Understanding the economic rationale behind each variable is crucial for applying the F-Score effectively.

Piotroski F-Score: Implementation (A, B)

These videos discuss the practical implementation of the Piotroski F-Score trading strategy.

Introduction:

• Once the F-Scores are calculated, the next step is to develop a trading strategy based on them.
• This involves deciding on the trading rules, timing, holding period, and risk management considerations.

Main content:

• Long-short portfolio:
  • Buy stocks with high F-Scores (e.g., 8 and 9) as they are expected to outperform the market.
  • Short stocks with low F-Scores (e.g., 0 and 1) as they are expected to underperform.
• Long-only strategy:
  • For investors uncomfortable with shorting, a long-only strategy can be implemented by buying only high F-Score stocks.
  • However, this strategy is exposed to market risk, requiring careful benchmark selection that reflects the high BM nature of the portfolio.
• Implementation considerations:
  • Data availability: Financial statements are typically disclosed with a lag, so backtesting and trading should start after the information is publicly available.
  • Holding period: The optimal holding period can vary, but testing different horizons is recommended.
  • Number of stocks: A diversified portfolio with a sufficient number of stocks is crucial to mitigate idiosyncratic risk.
  • Market context: Consider the institutional setup of the market, such as restrictions on short selling, when designing the strategy.
• Mock trading:
  • Before live trading, test the strategy using mock trading platforms to gain experience and refine the approach.
  • Monitor the performance over a reasonable period and adjust the strategy as needed.
• Discipline and risk management:
  • Stick to the predetermined trading rules to avoid emotional decisions driven by short-term market fluctuations.
  • Evaluate the performance of the strategy periodically and make adjustments if necessary based on a thorough analysis.

Key takeaways:

• The Piotroski F-Score can be implemented using long-short or long-only strategies.
• Practical considerations include data availability, holding period, portfolio diversification, and market context.
• Discipline and adherence to the trading rules are crucial for successful implementation.
• Mock trading helps refine the strategy and build confidence before live trading.

Module 4: Trading Strategy 2 - PEAD

Piotroski F-Score Wrap-Up

This video summarizes the key aspects of the Piotroski F-Score strategy and discusses implementation considerations.

Introduction:

• The video provides a recap of the Piotroski F-Score and highlights its practical implications.

Main content:

• Implementation issues:
  • Short-selling restrictions: In markets where short selling is prohibited or restricted, investors can adopt a long-only strategy or use derivative markets for shorting.
  • Investor preferences: Some investors may be uncomfortable with shorting due to its complexity or potential for unlimited losses.
  • Benchmark selection: When using a long-only strategy, the benchmark should be adjusted to reflect the high BM nature of the portfolio.
• Backtesting considerations:
  • When backtesting, simulate real-world conditions, including trading delays due to financial statement disclosure lags.
  • Test different holding periods and portfolio construction methods to find the most robust approach.

Key takeaways:

• The Piotroski F-Score can be adapted to different market conditions and investor preferences.
• Backtesting should accurately reflect real-world trading constraints and delays.

Post-Earnings Announcement Drift (PEAD) (A, B)

These videos explain the concept of Post-Earnings Announcement Drift (PEAD) and how to implement a trading strategy based on it.

Introduction:

• PEAD is a market anomaly that challenges the efficient market hypothesis. It refers to the tendency of stock prices to drift in the direction of unexpected earnings surprises even after the earnings information is publicly released.

Main content:

• Concept of PEAD:
  • When companies announce earnings that are better (worse) than expected, their stock prices tend to continue to rise (fall) for a period of time after the announcement.
  • This drift suggests that the market does not fully incorporate earnings information instantaneously.
• Trading strategy based on PEAD:
  • Standardized Unexpected Earnings (SUE):
    • Calculate the average earnings per share (EPS) for the past four years.
    • Subtract the average EPS from the actual EPS for the current period to get the unexpected earnings.
    • Divide the unexpected earnings by the standard deviation of EPS for the past four years to get the SUE.
  • Analyst estimates:
    • Obtain analyst estimates of EPS before the earnings announcement.
    • Subtract the average analyst estimate from the actual EPS to get the unexpected earnings.
    • Divide the unexpected earnings by the standard deviation of analyst estimates to get the SUE.
  • Decile ranking and trading:
    • Rank companies based on their SUE scores.
    • Go long on stocks in the top decile (highest SUE scores) and short stocks in the bottom decile (lowest SUE scores).
    • Adjust the number of deciles used in the strategy based on market conditions and risk appetite.
• Trading implementation:
  • Timing: Initiate trades after the earnings announcement is made public.
  • Holding period: The drift typically lasts for several weeks, with most returns accruing within the first 60 days.
  • Market considerations: PEAD is more pronounced in emerging markets and for stocks with less analyst coverage.
• Why does PEAD exist?
  • Behavioral biases: The disposition effect (investors' tendency to sell winners and hold losers) can contribute to the drift.
  • Short-selling constraints: Difficulties in short selling can limit the downward pressure on stocks with negative earnings surprises.
  • Transaction costs: The costs associated with trading can delay the full adjustment of stock prices.

Key takeaways:

• PEAD is a persistent market anomaly that presents an opportunity for profitable trading.
• The SUE is a standardized measure of earnings surprises that can be used to rank companies and identify potential winners and losers.
• Trading based on PEAD should be initiated after the earnings announcement and held for a relatively short period.
• Behavioral biases, short-selling constraints, and transaction costs are some potential explanations for PEAD.

Wrap-Up

This video emphasizes the importance of discipline in trading and provides advice on how to develop this crucial quality.

Introduction:

• The video concludes the module by highlighting the most important quality for trading success: discipline.

Main content:

• Importance of discipline:
  • Discipline is essential for sticking to the trading rules and avoiding emotional decisions driven by market fluctuations.
  • Traders who lack discipline often end up losing money, even if their trading strategies are sound.
• Challenges to discipline:
  • Early exits: The temptation to close profitable positions prematurely due to fear of losing gains.
  • Holding on to losers: The reluctance to cut losses, hoping for a market reversal.
  • Hindsight bias: The tendency to believe that past decisions could have been better, leading to rule violations in the future.
• Developing discipline:
  • Set clear trading rules and stick to them.
  • Avoid constantly monitoring stock prices.
  • Review the trading strategy regularly, but only make adjustments based on objective analysis, not emotional reactions.
  • Accept that losses are part of trading and focus on the long-term performance of the strategy.

Key takeaways:

• Discipline is paramount for successful trading.
• Develop discipline by setting clear rules, avoiding constant market monitoring, and reviewing the strategy objectively.
• Accept losses as part of the process and focus on long-term performance.

Global Course Summary

This course provides an introduction to trading strategies and benchmarks. It covers important concepts like market efficiency, how to read academic papers, and the importance of discipline in trading. The course presents two specific trading strategies:

• Piotroski F-Score: A value investing strategy that identifies financially strong companies within the universe of high book-to-market stocks.
• Post-Earnings Announcement Drift (PEAD): A momentum strategy that exploits the tendency of stock prices to drift in the direction of unexpected earnings surprises.

The course emphasizes the importance of understanding the economic rationale behind trading strategies and the need for rigorous backtesting before live trading. It also highlights the challenges of maintaining discipline in a dynamic and often emotional market environment.