Systematic trading (also known as mechanical trading) is a way of defining trade goals, risk controls and rules that can make investment and trading decisions in a methodical way.
Systematic trading includes both manual trading of systems, and full or partial automation using computers. Although
technical
Technical may refer to:
* Technical (vehicle), an improvised fighting vehicle
* Technical analysis, a discipline for forecasting the future direction of prices through the study of past market data
* Technical drawing, showing how something is co ...
systematic systems are more common, there are also systems using fundamental data such as those in
equity long:short hedge funds and
GTAA funds. Systematic trading includes both high frequency trading (
HFT, sometimes called
algorithmic trading
Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of ...
) and slower types of investment such as systematic trend following. It also includes
passive index tracking.
The opposite of systematic trading is discretionary trading. The disadvantage of discretionary trading is that it may be influenced by emotions, isn't easily back tested, and has less rigorous risk control.
Systematic trading is related to quantitative trading.
Quantitative trading includes all trading that use quantitative techniques; most quantitative trading involves using techniques to value market assets like
derivative
In mathematics, the derivative of a function of a real variable measures the sensitivity to change of the function value (output value) with respect to a change in its argument (input value). Derivatives are a fundamental tool of calculus. ...
s but the trading decision may be systematic or discretionary.
History
Systematic trading began with the growth of computers in the 1970s. The
Designated Order Turnaround (DOT) system used by the
New York Stock Exchange
The New York Stock Exchange (NYSE, nicknamed "The Big Board") is an American stock exchange in the Financial District of Lower Manhattan in New York City. It is by far the world's largest stock exchange by market capitalization of its liste ...
to electronically route orders.
In the 1990s, various trading strategies were developed by major banks, including statistical arbitrage, trend following and mean reversion. High-frequency trading strategies that combined computing power, speed, and large databases were gaining more popularity due to their success rates.
After 2000, millions of trades were executed by the largest hedge funds in mere seconds with their
black box systems.
Approach
Suppose we need to replicate an index with futures and stocks from other markets with higher liquidity levels. An example of a systematic approach would be:
# Identify, using
fundamental analysis, which stocks and futures should be used for replication.
# Analyze correlations between the targeted index and selected stocks and futures, looking for the strategy which provides a better approximation to index.
# Define a coherent strategy to combine dynamically stocks and futures according to market data.
# Simulate the strategy including transaction costs, rollovers, stop-loss orders, and all other wanted risk controls.
# Apply the strategy in the real world using algorithmic trading for signal generation and trying to optimize the
P&L, controlling continuously the risks.
Risk management
Systematic trading associates with a number of risks, the returns can be very volatile and funds can quickly amass substantial trading losses without proper risk management.
Therefore, systematic trading should take into account the importance of risk management, using a systematic approach to quantify risk, consistent limits and techniques to define how to close excessively risky positions.
Systematic trading, in fact, lends itself to control risk precisely because it allows money managers to define profit targets, loss points, trade size, and system shutdown points objectively and in advance of entering each trade.
By holding a diversified portfolio of individual systematic trading funds, the high level of volatility and manager-specific model risk can be mitigated.
Systematic Traders
*
Perry J. Kaufman, American systematic trader, index developer, and
quantitative financial theorist.
References
See also
*
Risk modeling Financial risk modeling is the use of formal mathematical and econometric techniques to measure, monitor and control the market risk, credit risk, and operational risk on a firm's balance sheet, on a bank's trading book, or re a fund manager's ...
*
Quantitative trading
*
Stock picking
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit f ...
*
Security analysis
Security analysis is the analysis of tradeable financial instruments called securities. It deals with finding the proper value of individual securities (i.e., stocks and bonds). These are usually classified into debt securities, equities, or s ...
*
Stock selection criterion
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Financial markets
Economic systems