Trading

Markets

This section covers markets: the universe that quantitative traders and researchers operate in.

Introduction Markets Limit-Order Book Arbitrage Market Making Signal-Based HFT Latency Statistical Arbitrage

Quantitative Trading firms are in the business of transacting in markets to turn a profit. In particular, they transact in markets with many fungible units that trade at a market-determined price. Some markets may have an associated exchange, which is simply a physical location where trades takes place. Exchanges facilitate transactions between buyers and sellers.

The function of all markets is to match the natural buyers and sellers:

  • Equity Markets, for shares in companies. They enable companies to sell themselves to investors.
  • Bond markets, for units of debt issued by companies and governments. They enable entities to take out loans from issuers.
  • FX markets, for exchange between currency pairs. They enable cross-border travel, trade and cooperation.
  • Commodity markets, for raw materials used to create goods. They enable producers to sell material to factories.
  • Funds markets, for shares in funds investing in any of the above, enable ordinary people to invest more easily in any of the above. In particular, funds markets that trade on exchanges are called Exchange-Traded Funds (ETFs) and have become extremely popular.

As we shall see in later sections, certain types of Quant firms (a type of high-frequency trading firm called a Market Maker) actively support these functions by acting as a middleman. While these markets have been traded before the advent of Quant firms, markets for derivatives of the above have recently exploded in popularity, and require substantial rigorous quantitative analysis to trade profitably. The most popular derivates are Futures contracts, for the obligation to purchase any of the above at a price agreed today. Options contracts, for the right, but not the obligation, to purchase any of the above at a price agreed today.

  • Futures contracts, which give the holder an obligation to purchase a certain asset in the future at a price agreed today.
  • Options contracts, which give the holder the right, but not the obligation, to purchase or sell an asset at a price agreed today.

These artificial markets enable participants to transact in even more advanced ways, tailoring which risks they want and which they don’t! For example:

  • Corn futures started out on the Chicago Mercantile Exchange to enable farmers to lock in the price of their corn at harvest, today.
  • Equity options enable investors in companies to buy insurance against the value of the companies in their portfolio dropping.

At the heart of markets is the concept of efficiency. Recall that the aim of markets is to enable their function (ie, to match their buyers and sellers). Hence, it may be measured in 2 ways:

  • Price efficiency - how well does the current market price accurately reflect the economic value of the good? This type of efficiency underpins a lot of modern economic theory.
  • Transaction efficiency - how much of the value traded ends up being lost between the buyers and sellers?
We shall see in the next sections, Quant firms make more profit in less efficient markets - but in a well-designed market, as multiple firms compete, they push the market towards greater efficiency, and hence provide a valuable service to modern capitalist economies.