While we shared a brief introduction to systematic trading here, this article looks at some of the more popular strategies in the space. While we’ve focused on popular strategies in the Indian context, all the below mentioned styles are prevalent in global markets as well.
At the broadest level, most strategies can be classified into one of two buckets: directional or relative value.
Directional strategies involve taking a position in a single security or a basket of securities with the intention of capturing the upward/downward movement of the underlying portfolio. The positions could be all long or all short or a combination of long and short across the portfolio. Such strategies will inherently carry directional risk and perform best when the underlying markets move strongly in one direction. Trend following and factor investing are examples of directional strategies.
Relative value strategies on the other hand take an offsetting long and short position in 2 or more securities/portfolios with the intention of capturing the relative movement between them. Such strategies generally have very low directional risk, meaning they can do well even when markets don’t move in a particular direction. Arbitrage, pairs trading and market neutral are popular examples.
Popular Strategies
Trend following
One of the most popular styles of trading across asset classes, this relies on capturing underlying moves in either direction, while the holding period could vary between a few seconds to a few months. Especially popular among technical traders, this strategy involves identifying a trend in underlying prices and/or other market variables and getting in on the same side. For e.g. if prices in a particular stock have been moving up for the past few days, such a strategy would buy the stock. The primary decision variables here are a) the logic used to identify the trend in the security, b) the size of the position in each security and c) the rules for exits. Such strategies work best when there are strong underlying moves in one direction and are consequently best suited to more volatile asset classes such as equities and commodities.
The simplest indicator that finds use in trend following is a moving average (MA), which is a simple average of price over the last few periods (minutes, hours, days or weeks). For instance, one could create a simple strategy wherein you buy the underlying security whenever its 20 day MA goes above the 50 day MA and sell when it goes below. Such a strategy can then be implemented as a long only, long short or short only variant depending on the requirement and the use case.
Factor investing
Factor based investing has existed in the traditional investing world for decades, with value investing being an established style that has a huge following. When such a style is applied with a defined set of rules, it can be classified as a factor strategy. A factor is an observable metric or attribute which is a return driver, based on which a target universe can be segmented into investable subsets. In the value example above, a measure like P/E or P/B could be used for listed equities and the decile with the lowest P/E or P/B could be chosen as the target portfolio, with additional filters as required. Apart from value, other well known style-based factors are momentum, quality, low volatility and dividend yield. Most factor based strategies can be setup as long only portfolios or long short portfolios. The advent of smart beta funds has meant a lot of long only factor portfolios are now available as low-cost ETFs or index funds, especially in equities. Some of the style factors can be defined in asset classes such as commodity futures and debt also, but the quality and breadth of data and securities in equities makes it the most appropriate asset class for this approach. Most styles and factors however go through cycles and long periods of sustained underperformance are not uncommon, as seen with the value factor over the last decade. Both NSE and BSE have a lot of listed factor indices and we have seen quite a few investment products linked to such indices.
Equity market neutral
Market neutral strategies are very popular among hedge funds and while theoretically these can be run across asset classes, equities remain the most obvious choice given the number of liquid securities available and the quality of data. In simple terms a market neutral portfolio is a combination of a long and short portfolio, with little to zero directional exposure to the market, which means they can do well irrespective of the underlying direction of the market. The long and short portfolios are typically segregated based on one or more factors or variables and the choice and relative weights assigned to the individual components is the key aspect of such strategies. The input data used for generating such variables could be based on publicly available sources like earnings, price, volume or alternative data like sentiment scores. The other key considerations are the choice of the universe, weights of individual securities and whether the overall portfolio should be neutral in terms of market value or some other measure like beta or volatility.
As an example of a momentum-based market neutral strategy, one could sort the top 200 names by market cap and filter for liquidity and then segregate the remaining universe into quintiles based on their most recent 12-month price return. The top quintile would be the long portfolio and the bottom quintile would be the short portfolio. Each security could be equal weighted with the long and short portfolios being equal in value terms. Such a portfolio would benefit from the relative movement of the long portfolio versus the short portfolio, irrespective of the underlying market movement. With the advances in data processing and availability, these strategies have tended to become increasingly sophisticated while also being incredibly scalable and add good diversification to long only portfolios.
Pairs trading
Similar in nature to equity market neutral strategies, pairs trading involves taking offsetting positions in two securities that have common drivers of return for e.g. stocks in the same sector, correlated equity indices or similar commodities. The underlying philosophy is generally a convergence between the two securities, meaning that the spread between them will reduce (divergence trades are less common). Since there are (generally) only 2 securities involved, these trades are easy to setup across asset classes and fairly easier to monitor than portfolio based market neutral strategies. There is also an additional difference in that the 2 securities chosen either have structurally common return drivers or are statistically correlated. Such trades are also common in the derivatives universe, where spread trades can be setup across various maturities of the same underlying.
A simple example of this would be to look at the historical return ratio (say 24 months) of 2 similar stocks in the same sector (say TCS vs INFY) and when the current ratio is 2 standard deviations away from the historical average, the trade would be that the ratio will converge towards the average. Thus the trade would be to go long the stock that has underperformed (relative to long term average) and go short the stock that has outperformed over this period. Given the nature of the setup, these trades are sporadic and opportunistic and therefore tend to be uncorrelated to other strategy styles.
Options strategies
While options can be incorporated as trading instruments in some of the above styles, there are certain strategies which leverage the non-linear nature of options and focus on deriving returns from certain properties of options. Apart from a directional view, options can be used to take a view on other risk factors (called Greeks) such as volatility or convexity or time-decay. One of the most popular versions of this strategy involves selling at-the-money puts and calls (straddle) and continuously hedging the residual delta position, profiting from the eventual time decay of options. Such strategies rely on an efficient hedging strategy as well as strong risk management. Similarly, options positions can be setup to take a view on large moves arising in the short term by buying both calls and puts. Since some of the variables used in these strategies are not accessible through any other style, this has become an increasingly popular strategy style across asset classes.
Other styles
While we have discussed a few popular systematic strategies, most investment strategies can follow a systematic approach and a comprehensive overview would likely require a book.
Most traditional investment vehicles like mutual funds and portfolio management schemes (PMS) would run some form of factor investing, if they follow a systematic approach. New age investment platforms like Smallcase and WealthDesk also offer portfolios that are driven by factor investing. Alternative investment funds (AIF) and proprietary trading desks are generally active in long short and market neutral strategies.
