Quant trading has both pros and cons. In this article, we look at 8 pros and cons of quant trading. Even though we list both 8 pros and cons of quant trading, we believe the pros far outweigh the cons. The main reason for that is that you actually backtest an idea or hypothesis and at the same time reduce behavioral mistakes.
Trading, an abbreviation for quantified- and quantitative trading, is growing in popularity because of the possibility of having the computer do all the work, thus reducing emotions and behavioral mistakes. Quant trading was previously only available for big trading firms, but today this is a viable option for most retail traders. We believe most retail traders stand a better chance using the systematic approach that quant trading offers.
(Before we go on we’d like to mention that we have a backtesting course that covers all aspects of how to backtest.)
What is quant trading?
Quant trading uses mechanical and quantified trading rules and strategies based on backtesting, statistics, and numbers. It’s data-driven analysis and relies on automation and scale.
Trading is challenging and needs to be treated as a profession. It is difficult to find profitable systems, and yet another hurdle is overcoming behavioral mistakes. Emotions, biases, greed, and fear are just a few of the issues you have to address. Trading is all about making decisions about an uncertain future.
Fortunately, you can dramatically reduce human errors with the advent of technology such as VPS (a virtual private server), software, coding, and programming.
Quant is an abbreviation for quantitative or quantified – pick your definition – and is sometimes referred to as algo trading. Quant trading, also called algo or algorithmic trading, involves making 100% testable systems run alone on a trading platform without human interference. The systems can, for example, run on your VPS where you start the systems and portfolios before trading hours and stop them after trading hours.
Quant trading lets you focus on developing quantitative trading systems and portfolios while all the trading and execution run automatically on their own. This way, you reduce the possibilities of human errors drastically. Furthermore, it gives you time to pursue other things, perhaps even having a separate source of income.
Related reading: 8 Quantitative Trading Strategies
How does quantitative trading work?
Quantitative trading uses predefined trading rules for buy and sell signals and scans the market at preset intervals, often with some seconds “rest” between each scan, so your computer or VPS doesn’t get overloaded, depending on how many strategies you run.
You can develop strategies by testing various hypotheses or let your computer look for potential market inefficiencies while sleeping. The latter is increasingly common, but it involves rigorous out-of-sample testing.
As a quant trader, you can never rest on your laurels. Trading requires constant work to make sure you have a plan B (and replace strategies when they stop working).
What steps are required for quant trading?
The following steps are required for quant trading:
- First, you need to formulate a plan or hypothesis. The strategy might be mean-reversion, momentum, trend-following, or perhaps a day trade.
- When you have an idea, you must be able to formulate the design down to pinpoint accuracy.
- When you have an automated strategy, you must implement it into your existing arsenal of quantitative trading strategies. Does it add value and diversification to the existing strategies?
- If the strategy passes both the out-of-sample test and the diversification criteria, you add it to your portfolio and software, for example, Amibroker.
- When the four previous tasks are done, implement the strategy in your software and let it run without interference.
You might also read our previous article on how to find trading edges.
What are the pros of quant trading?
The pros of quant trading can be summarized into 8 advantages:
No human intervention
The only intervention from your side is in the development process. As soon as the strategy is ready, it’s all about hands-off. Your computer is not liable for behavioral mistakes.
Quantitative trading reduces cognitive errors
Quantitative trading reduces human errors, and accuracy improves, reducing the possibility of errors drastically. The quant strategies are double-checked and rechecked. Any technical indicator is defined to the smallest detail, and no judgment error is made.
Quantitative trading strategies give leverage
Increased speed. An algorithm can analyze 100 strategies with several criteria in a split second. No human can accomplish this feat. Depending on your time frame, speed is of the essence. Automation makes you disciplined and gives you leverage and a wide range of capabilities.
Quantified strategies allow backtesting
Quant trading systems let you backtest on historical data with no room for interpretation. There is no discretionary judgment, which is impossible to backtest and test scientifically. Having quantitative trading strategies that are backtested should give a boost to your confidence.
Infinite numbers of strategies can be implemented
Computing power lets you trade almost infinite numbers of quantitative trading strategies, systems, and portfolios. The magic behind Jim Simons’ Medallion Fund’s spectacular performance is its enormous number of strategies spread across different markets and time frames. Strategies that perform differently from each other lead to a smooth equity curve high profit factors and Sharpe ratios.
Automated trading frees up time
Quant trading lowers your costs and increases efficiency. There is no need to sit in front of the screen all day; it frees time you can spend on getting additional income. Moreover, there is reason to believe the friction costs of getting in and out of position go down.
Quantitative trading systems resemble your backtests
The order entry speed is much higher than what you can do physically. When the analysis scan is done, an order gets sent out in one-hundredth of a second. The speed of entry and exit helps you resemble your backtest to the exact detail.
Systems let you follow your plan
Quant trading systems make you consistent. A plan requires you to follow the plan, and predefined rules for buying and selling make you follow the plan down to the smallest detail. Plan the trade and trade the plan. Despite ups and downs in the market, your quant trading systems help you stay consistent and disciplined. Research as much as you can.
What are the cons of quant trading?
The cons of quant trading can be summarized into 8 disadvantages.
Quantitative trading is prone to curve fitting
The greatest pitfall is curve fitting and optimization. The reliance on historical data inevitably leads to many strategies resulting from chance and randomness. Out-of-sample tests reduce the element of curve fitting, but even that can’t eliminate it.
As Nassim Taleb says: if you want to bankrupt a fool, give him lots of information. Randomness is much more prevalent than most traders believe. It’s easy to fool yourself by trusting the data 100%.
We recommend testing your quantitative trading strategies in a paper account for at least six months before you go live, depending on the time frame and number of observations. The more observations, the shorter the testing period is required.
Being a quant requires coding skills
You need to learn to code and program. While this might scare off many potential traders, especially those over 40 years of age, it doesn’t require much effort to learn. Besides, learning has diminishing returns the more you learn. You make a great leap by learning little, but the marginal utility falls as you learn more. Just knowing a little helps you a long way.
You are at a considerable disadvantage if you depend on hiring someone to do most of your tasks. Do yourself a favor and self-study for a few months, and you’ll make giant leaps in your trading.
Having said that, the most important thing is still trading. You can’t become a good trader solely by being good at coding. You need to understand why programmers and coders are bad traders.
Quants are liable to black swans
A lot can go wrong when you automate. Errors in code can lead to multiple trades, potentially ruining your account, which happened to Knight in 2012. Moreover, a tiny mistake in where you put parenthesis can substantially alter the strategy. “Black swans” happen. You might think you have everything planned, but you can’t prepare for what you don’t know.
Even though computers let you automate all the tasks, we don’t recommend leaving it completely alone. Connectivity and power outages are both potential black swans. For example, if you are using a VPS, a sudden reboot on their end can create havoc in your systems. However, that’s why we have smartphones (?).
Quant trading involves fixed costs
Quant trading requires costs and subscriptions. You need quality historic share/future price data, live data fees, VPS, and software. You can expect a price tag of a few hundred USD a month, depending on your level of service.
Some strategies are impossible to code – keep it simple
Some strategies can be difficult to code, if not impossible. They might be complex and require programming skills you don’t have, or you somehow can’t quantify the criteria. Nevertheless, complex quantitative trading strategies are not necessarily better than simpler ones, quite the opposite.
An underappreciated trading skill is making “simple” strategies with few variables. Our own anecdotal experience indicates many programmers turned traders make things too complicated.
A computer is “dumb”
A computer is “dumb” – you need to code the computer what to do. Artificial intelligence has come a long way, but the human mind is still superior to your trading software. A human mind can understand irrational behavior. A computer can’t.
Quants need to develop strategies continually
Quant trading requires the constant development of existing and new strategies. The reality of automated trading is that most, if not all, quantitative trading strategies eventually die or get “arbed” away. The only constant in the market is change.
Loss of control
Ironically, the loss of control might make you more uncertain. For example, many quant traders turned off their programs in March 2020 when the Covid-19 created enormous volatility. On the other hand, if you already “know” the strategy will not work, it can be problematic just to ignore one or two trades. There are always temptations to fiddle with the systems.
Pitfalls are plentiful, and you are liable to black swans. You depend on your technology, and your code might make your portfolio a disaster. You can’t prepare for all scenarios.
Pros and cons of quant trading – conclusion
Despite having an equal number of pros and cons, we believe the pros outweigh the cons (by far). Trading is difficult but having a systematic approach is essential for success.
To increase your chances of success, we believe quantitative trading is the way to go despite some disadvantages. Discretionary trading is hard and requires you to sit in front of the screen most of the day, perhaps unnecessary, but that’s often the result when you have no specific plan(s). Quantified rules let you trade with confidence and make sure your decisions are made objectively.
What is quant trading, and how does it differ from traditional trading?
Quant trading, short for quantitative trading, involves using computer algorithms and predefined rules to make trading decisions automatically. It differs from traditional trading by relying on systematic and data-driven approaches, reducing human intervention and emotional biases.
Why is quant trading gaining popularity among retail traders?
The advantages of quant trading include hands-off trading with minimal human intervention, a reduction in cognitive errors. Quant trading is becoming popular among retail traders due to advancements in technology, making it possible for computers to handle the trading process. This approach reduces emotions and behavioral mistakes, providing a systematic and efficient way to trade.
How does quant trading address the loss of control and uncertainties?
Quant trading may lead to a loss of control in certain situations, such as extreme market volatility. Traders need to resist the temptation to interfere with automated systems and understand that constant strategy development is necessary to stay ahead of market changes. It is recommended to test quant trading strategies in a paper account for at least six months, depending on the time frame and number of observations.