AppFin PW Lec01

Applied Finance
Statistical tools in algorithmic trading
Piotr Wojcik
WNE UW
Lecture #1, 20.11.2019

High-frequency data definition, characteristics and sources
Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 1 / 68

Table of contents
1 Organizational matters
2 Statistical properties of returns
3 High-frequency data
4 Empirical characteristics of high-frequency data
5 High-frequency data sources

Aim of this part of the course
The aim of this part of the Applied Finance course is:

to give basic theoretical background for high-frequency algorithmic
trading,
to learn characteristics of high-frequency data and steps needed to
prepare the data, aggregate it to desired frequency,
to show how to build and verify profitability of simple own trading
strategies,
to learn specifics of backtesting/validation of machine learning
algorithms applied on time series data.
R environment will be used for practical examples – its previous
knowledge is expected.

Lectures and labs
This part of the course will consist of four lectures:

1 High frequency data
2 Types of strategies, backtesting (validation)
3 Building an automated strategy
4 Statistical arbitrage and event arbitrage
Lectures will be accompanied by two practical lab sections with R:
1 Dealing with time series data incl. intraday, data aggregation
2 Applying simple strategies

Literature
Aldridge, I. (2013), High-Frequency Trading: A Practical Guide to

Algorithmic Strategies and Trading Systems
Chan, E. (2008), Quantitative Trading: How to Build Your Own Algorithmic
Trading Business
Chan, E. (2013), Algorithmic Trading: Winning strategies and their
rationale
Fabozzi, F.J., Focardi, S.M. and Kolm, P.N. (2010), Quantitative Equity
Investing: Techniques and Strategies

Statistical properties of returns

Returns
financial data is typically analyzed using returns,

a return is a difference between two subsequent price quotes
normalized by the earlier price level,
independent of the price level, returns are convenient for direct
performance comparisons across various financial instruments.

Simple and logarithmic return
A simple return measure can be computed as:
Pt − Pt −1 Pt
Rt = = − 1,
Pt −1 Pt −1
where
Rt is the return for period t,
Pt is the price of the financial instrument in period t,
Pt −1 is the price of the financial instrument in period t − 1.
Despite the intuitiveness of simple returns, much of the financial literature
relies on log returns, which are defined as:
Pt
rt = log = log Pt − log Pt −1 ,
Pt −1

Why log returns?
Log returns are often preferred to simple returns for the following reasons:
if log returns are assumed to follow a normal distribution, the
underlying simple returns and the asset prices itself follow a
lognormal distribution,
lognormal distribution better reflects the actual distributions of asset
prices (eg. asset prices are generally positive),
lognormal distributions have fatter tails than in normal distributions
(like distributions of asset prices),
although not perfect in modeling fat tails of asset prices, lognormal
distributions approximates it better than normal distributions.

Average return
both simple and log returns can be averaged over time to obtain
lower-frequency return estimates,
an average of simple and log returns can be computed as usual
arithmetic averages:
T
1X
E (R ) = Rt
T
t =1
T
1X
µ= rt
T
t =1

Volatility
variation in sequential returns is known as volatility, which can be

measured in a variety of ways,
the simplest measure of volatility is variance of simple or log returns:
T
1 X
var (R ) = (Rt − E (R ))2
T −1
t =1
T
1 X
2
σ = (rt − µ)2
T −1
t =1

Another common statistics
Other common statistics used to describe distributions of prices, simple or

log returns are skewness and kurtosis.
skewness measures whether a distribution skews towards either the
positive or the negative side of the mean, as compared with the
standardized normal distribution,
kurtosis is a measure of fatness of the tails of a distribution; the fatter
the tails of a return distribution, the higher the chance of an extreme
positive or negative return.
Extreme negative returns can be particularly damaging to a trading
strategy, potentially wiping out all previous profits.

Skewness and kurtosis
Skewness can be measured as:
(Rt − E (R ))3
PT
1 t =1
S (R ) = 3
T −1 (var (R )) 2
Skewness of the standardized normal distribution is 0.
Kurtosis can be computed as follows:
(Rt − E (R ))4
PT
1 t =1
K (R ) =
T −1 (var (R ))2
The standard normal distribution has a kurtosis of 3.

Autocorrelation
another metric useful to describe distributions of returns is

autocorrelation,
it is a measure of serial dependence between subsequent returns
sampled at a specific frequency,
autocorrelation value of order p can be determined by:
PT
t =p+1 [(Rt − E (R ))(Rt −p − E (R ))]
ρ(p) = qP qP
T T
t =p+1 ( Rt − E (R )) t =p+1 (Rt −p − E (R ))
above equation uses simple returns to compute autocorrelation, but

returns of any type can be used instead

Autocorrelation in trading
autocorrelation allows us to check whether there are any persistent

momentum/reversal relationships in the data that we could trade
upon,
for example, it is a well-known stylized fact that a large swing, or
momentum, in the price of a financial security is typically followed by
a reversal,
using autocorrelation at different frequencies we can actually
establish whether the patterns persist and whether we can trade upon
them.

High-frequency data

What is high-frequency data?
20 years ago it was daily data

large data sets consisted of 1000s of stocks over 20–30 years
(5–10 millions of data rows),
now it is tick-by-tick or transaction level data on prices, quotes,
volume, order book
large data sets consist of 1000s of stocks over 10–15 years
(billions of data rows)

Tick data
The highest-frequency data is a collection of sequential “ticks”, arrivals of

the latest quote, trade, price, and volume information. Tick data usually
has the following properties:
a timestamp,
a financial security identification code,
an indicator of what information it carries:
bid price,
ask price,
available bid volume,
available ask volume,
last trade price,
last trade size,
option-specific data, such as implied volatility,

A timestamp
a timestamp records the date and time at which the quote originated,
it may be the time at which the exchange or the broker-dealer
released the quote, or the time when the trading system has received
the quote,
the quote travel time from the exchange or the broker-dealer to the
trading system can be as small as 20 milliseconds,
therefore all sophisticated systems include milliseconds as part of
their timestamps.

Bid and ask prices and volumes
the bid quote/price is the highest price available for sale of the
security in the market,
the ask quote/price is the lowest price entered for buying the security
at any particular time,
available bid and ask volumes indicate the total demand and supply,
respectively, at the bid and ask prices.

Bid-ask spread
the bid-ask spread is the difference between the bid quote and the
ask quote at any given time,
the bid-ask spread is the cost of instantaneously buying and selling
the security,
the higher the bid-ask spread, the higher the gain the security must
produce in order to cover the spread along with other transaction
costs,
most low-frequency price changes are large enough to make the
bid-ask spread negligible in comparison
in tick data incremental price changes can be comparable or smaller
than the bid-ask spread.

Sample bid and ask quotes

Histograms of bid and ask spreads

Last trade price and size
the last trade price shows the price at which the last trade in the
security cleared,
last trade price can differ from the bid and ask,
the differences can arise when a customer posts a favorable limit
order that is immediately matched by the broker without broadcasting
the customer’s quote,
last trade size shows the actual size of the last executed trade.

Empirical characteristics of high-frequency data

Empirical characteristics of high-frequency data
High-frequency data have some unique characteristics:

large volumes,
discrete-value prices,
existence of a daily periodic or diurnal pattern.

Large volumes
Reuters transmitted more than 275,000 prices per day for foreign
exchange rate spot market,
median stock in the Russell 3000 produces approximately 2,100 ticks
per trading day,
number of observations in a single day of tick-by-tick data is
equivalent to 30 years of daily observations,
the quality of data does not always match its quantity,
as a consequence, there are also considerable potential of errors in
the data. The “bad ticks” need to be cleaned or, be filtered prior to
further analysis.

Discrete price changes
changes in transaction price are discrete and only fall on a set of

values,
this is because different exchanges make certain rules to restrict price
changes to retain stability and functionality,
the smallest allowable price change is called a tick,
price changes must fall on multiples of the tick,
in some exchanges there are also other limits on intra-day price
change,
the discreteness leads to a high degree of kurtosis.

Histograms of price changes (in ticks)

Table of price changes (in ticks)
63 trading days and 60.328 transactions,

price changes between trading days ignored,
distribution of positive and negative price changes was approximately
symmetric, with high frequency in zero and one ticks.

Empirical summary statistics for log returns
Kurtosis increases with the frequency of the data.

Periodic patterns
high-frequency data often contain strong periodic/diurnal patterns

(seasonality),
transaction volume and volatility follow so called U-curve pattern – are
significantly high after the open and shortly before the close,
in the foreign exchange markets, where there is no open and close,
volume and volatility is systematically high in active periods of the
day, where the active periods of global markets overlap.

U-shape for volume
similar U-shape could also be

found in volatility, return and
bid-ask spread,
in most cases, the minimum is
observed between 11:30 am
and 1:30am.

U-shape reasons
The reason for the U-shaped curve is simple to explain:

at the beginning of a trade day, all the information is well absorbed by
the market overnight,
market participants have analyzed the information and made their
trade strategy for the coming day,
at the opening they adjust their positions and simultaneously submit
orders to build new position or empty old position,
that is why more transactions take place and drive the volatility high,
during the rest time of the day, they prefer to “wait and see”,
especially during lunch break,
just before closing, all market participants make their final
adjustments according to the information they received during the
trade day, which pushes market volatility to another high.

How the global FX market works
over-the-counter (OTC) or off-exchange trading is to trade financial

instruments directly between two parties,
due to the OTC nature, there’s no central marketplace for currency
transactions, therefore no single quotes,
there’re three main trading centers: London, New York and Tokyo,
currency trading happens continuously throughout the day around the
world,
as the trading session in Asia ends, the European session begins,
then followed by the North American session and finally back to the
Asian session.,
strong seasonality can be found in OTC market, however, not the
typical U-shaped curve.

Global FX market – analysis difficulties
analyzing the global FX market is a difficult task,

apart from the different time zones, different countries also have
different public holidays,
another problem is with the day-light saving time: many countries, like
most Asian countries do not utilize day-light saving time at all,
those differences must be considered in cross-market comparison.

Seasonalities in FX global market
empirical studies confirm the existence of significant seasonality in

global FX market,
for USD/EUR as example: the main daily maximum of volatility occurs
between 14:00 GMT and 16:00 GMT, when both the European and
the American markets are active,
the main daily minimum is between 3:00 GMT and 4:00 GMT, when
both European and American markets are closed, while lunch-break
in Asian markets,
other currencies reported very similar periodic pattern,
the market activity is high when relevant markets are open and
actively traded, especially when active period of two or more relevant
markets overlapped.

Volume in FX market
late afternoon in EU is both

active time of EU and US
markets,
Euro/Dollar exchange rate often
represents the highest volatility
during this period.

Intra-week pattern
intraweek high frequency data also showes significant seasonality,

almost all exchanges are closed on weekends and holidays and
therefore no trading takes place,
for weekdays the level of activity is very different,
a day-of-the-week effect can be observed across different exchanges:
in general there’s a minimum of activity on Monday and a
maximum of activity on the last two working days of the week,
more precisely, the market activity increases gradually from Monday
to Friday,
similar periodic patterns can be also found in return, volatility and
spread.

Intra-week volume – W-shaped curve

High-frequency data sources

Commercial sources for historical high-frequency data
NYSE Trade and Quotes (TAQ),

Bloomberg (American equities) – Rblpap – R interface,
Olsen & Associates (FX),
Interactive Brokers (IBrokers) – IBrokers – R interface,.

Commercial sources for historical high-frequency data
tickdata
https:
//www.tickdata.com/historical-market-data-products/
quantquote
https://quantquote.com/
Πtrading.com
http://pitrading.com/historical-data.html
kibot
http://www.kibot.com/

https://www.tickdata.com/historical-market-data-products

https://quantquote.com/

https://quantquote.com/products_tick-data.php#sample – sample data

http://pitrading.com/historical-data.html

http://www.kibot.com/

http://www.kibot.com/Buy.aspx#free_historical_data/ – free samples

Sample FREE sources for historical high-frequency (intraday) data
www.dukascopy.com (all major currency pairs, some commodities,

indices and many stocks),
https://www.alphavantage.co/ (1-minute data for past 10-15
trading days),
bossa.pl (Polish stocks, bonds and futures),
https://www.truefx.com/ (FX market)

https://www.dukascopy.com/swiss/english/marketwatch/historical/

http://www.dukascopy.com/swiss/english/marketwatch/historical/










https://www.alphavantage.co/

https://www.truefx.com/

http://bossa.pl/notowania/pliki/intraday/

http://bossa.pl/notowania/pliki/intraday/metastock/

http://bossa.pl/notowania/pliki/intraday/metastock/ – cont’d

http://bossa.pl/notowania/pliki/intraday/metastock/ – cont’d

Thank you for your attention!

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Applied Finance

Statistical tools in algorithmic trading

Lecture #1, 20.11.2019

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 1 / 68

2 Statistical properties of returns

4 Empirical characteristics of high-frequency data

5 High-frequency data sources

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 2 / 68

The aim of this part of the Applied Finance course is:

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 3 / 68

This part of the course will consist of four lectures:

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 4 / 68

Aldridge, I. (2013), High-Frequency Trading: A Practical Guide to

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 5 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 6 / 68

financial data is typically analyzed using returns,

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 7 / 68

A simple return measure can be computed as:

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 8 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 9 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 10 / 68

variation in sequential returns is known as volatility, which can be

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 11 / 68

Other common statistics used to describe distributions of prices, simple or

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 12 / 68

Skewness can be measured as:

Kurtosis can be computed as follows:

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 13 / 68

another metric useful to describe distributions of returns is

above equation uses simple returns to compute autocorrelation, but

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 14 / 68

autocorrelation allows us to check whether there are any persistent

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 15 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 16 / 68

20 years ago it was daily data

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 17 / 68

The highest-frequency data is a collection of sequential “ticks”, arrivals of

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 18 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 19 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 20 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 21 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 22 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 23 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 24 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 25 / 68

High-frequency data have some unique characteristics:

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 26 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 27 / 68

changes in transaction price are discrete and only fall on a set of

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 28 / 68

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 29 / 68

63 trading days and 60.328 transactions,

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 30 / 68

Kurtosis increases with the frequency of the data.

high-frequency data often contain strong periodic/diurnal patterns

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 32 / 68

similar U-shape could also be

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 33 / 68

The reason for the U-shaped curve is simple to explain:

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 34 / 68

over-the-counter (OTC) or off-exchange trading is to trade financial

Piotr Wojcik (WNE UW) Lecture #1, 20.11.2019 35 / 68

analyzing the global FX market is a difficult task,