(Richard Tibbetts is Chief Technology Officer at StreamBase Systems. Follow him on Twitter as @tibbetts)
When it comes to algorithmic trading, everyone is looking for alpha, outsized returns which exceed your risk. In an efficient market, there would never be any alpha, so seeking alpha means seeking inefficiencies in the market. The problem with market inefficiencies is that they don't last. The mere act of using them depletes the available revenue - when others join in, the opportunity can go away very quickly.
So not only do you have to find alpha, you have to find sustainable alpha. Since a lot of customers use StreamBase and complex event processing for algorithmic trading, I see a lot of alpha seekers. Three attributes seem to consistently contribute to sustainable alpha: being smart, being fast, or being dirty. To create a sustainable strategy, mix in at least one, and preferably more of these components.
Smart — The best-known way to create sustainable alpha is to be smarter than the competition. Unfortunately, on Wall Street, genius is a commodity, so trading techniques must be both creative, and evolve. Industry analyst AITE Group found that some algorithms have a shelf life of only a few weeks. And, since market conditions are constantly changing, “smart” is never “static.” Finally, if you can discover something based on easily available public information, the other geniuses won't be far behind. So smart, the best way to achieve alpha, must also be creative, and must also constantly evolve and get smarter as market conditions evolve.
Fast — Another way of securing alpha is to be faster than the competition. This means making decisions quickly, then executing your trades before competitors can execute theirs. Efficiency and speed is important for any system, but if you are betting on being the fastest, ultra-low-latency execution management will be keeping you up at night. The challenge with fast is that it's easy to spend money to get faster. If you are a small company, larger competitors with will always be able to outspend you, so you must take advantage of your size. In 8 Lessons for Entrepreneurs – A Case Study Based on Phase Capital, the lessons from this small, innovative firm included leveraging automation, building incrementally and quickly, and choosing the right partner. On the other hand, large companies can fight off more nimble competitors with their scale, reach, and ability to choose and deploy bleeding edge technology that smaller IT departments cannot support. In either case, you must exploit your natural advantages to stay fast.
Dirty — Finally, you can be dirtier than the competition. I don't mean being ethically questionable. Instead, I mean working with markets, information, and technology that others avoid. Developers and quants both like systems that make sense, clean systems that have been developed by like-minded engineers and are easier to work with. Getting your hands dirty with legacy systems, systems that haven't yet been polished to industry standards, or systems which were never designed for trading exploitation is one way to distinguish yourself. For example, trading in emerging markets often requires getting your hands dirty. But it also lets you trade securities that others aren't following as closely. Trading uncommon or unknown products is one strategy for finding alpha. So is trading based on non-financial information. This has famously been done with weather data and Amazon sales information. Steve Steinberg gave a great presentation on this at O'Reilly's Money:Tech. Working with these data sources may require checking your engineering sensibilities at the door, but the rewards can be substantial.
Lots of trading firms use complex event processing as their platform to create alpha-seeking strategies. But not all CEP platforms are the same. So, when selecting an alpha-generating technology platform, it is important to know what kind of strategy you are building, and what key technical elements you’ll need to meet your requirements.
To build smart strategies, a development platform must have a flexible programming language, good development tools (debugger, profiling, testing), and a good backtesting environment so that you can design, test, deploy, and evolve smart alpha-seeking strategies. There is no one more frustrated than a smart quant who is told by developers that his new strategy can't be built in their system. For example, can your platform handle multi-security strategies? Cross-asset strategies? Plug in analytics written in your quant’s' favorite programming languages? All these features and more may be required to support smart strategies.
To build fast strategies, you will need a platform and deployment environment that supports ultra-low latency. This will generally require collocation at the site of your favorite exchange. If your strategy requires interaction with multiple exchanges, than your deployment architecture must take into account the wide area network latencies involved. Your development platform should also support low-latency data transports like Infiniband, and have a multi-threaded architecture that optimizes the processing of individual events. And for some fast strategies, throughput and scalability will also be important, so multi-core technologies, clustering, and cloud computing techniques may be required.
To build dirty strategies, your platform needs to ingest any kind of data you might need. This could include unstructured data processing for handling news, analyst reports, underlying data that effects, for example, a derivative like weather information, and so on. An effective platform for dirty alpha-seeking strategies requires APIs and development tools which support building connectivity quickly. Pre-built vendor connectivity is nice to have, but for a dirty strategy you are likely to connect to arcane information sources or technologies.
If you are planning to find alpha, know what your goals are. When selecting a platform, make sure it supports the kind of alpha you will generate. If you choose correctly, the platform will help secure your alpha against the competition.