A trader is a person who engages in the buying and selling of financial assets in a financial market. Anyone may appoint this person or merchant to act as their representative while engaging in transactions.
Contrary to long-term investors, day traders focus on making quick profits. To capitalize on short-term price fluctuations, traders keep assets for relatively short periods. A typical investor, on the other hand, keeps their money in the bank for years, some may even think is forex trading legit.
Which person is a Quant or Quantitative Analyst?
A quantitative analyst is a person responsible for developing the intricate framework that banks and other financial institutions use to value or trade securities in the market. There are two distinct kinds of quants.
Financial securities and trading tools prices like trading forex are provided by front office quants, who work directly with traders.
Quants in the back office who do the heavy lifting of researching and validating the framework.
Let’s go on and learn more about the mathematical foundations of algorithmic trading.
Why is Math Necessary for Algorithmic Trading?
Most of a quant’s time is spent monitoring the market. The question that piques my attention is, “How do quants anticipate or foresee based on market data?”
You guessed it: Math!
The method involves acquiring and analyzing stock market data purchases. They then use this information to calculate the percentage of probability (for example, 65%, 75%, etc.) associated with the future direction of stock prices.
This is sometimes referred to as “forecasting the long-term or short-term potential of stock values.”
The developers of High-Frequency Trading (HFT) algorithms bear in mind the need to process a high number of deals in a short time.
For instance, in one millisecond the value may go up or fall, and so, hundreds of deals happen in every passing moment in HFT.
The emergence of Mathematics in Trading and Its Development Over Time
Now, it wasn’t until the late sixties that mathematics made its initial foray into the financial realm of Stock Trading.
Edward Thorp, a math professor at the University of California, wrote a book called Beat the Market in 1967.
This book, he said, was the one certain strategy to make money in the stock market.
The foundation of this approach was a strategy he developed to win at blackjack tables in casinos.
Its purported success led casinos to alter their policies so that “Beat the Market” could be played.
In particular, the Beat the Market strategy consisted only of selling stocks and bonds at a high price and then repurchasing them at a reduced price.
With the success of his method, Edward Thorp established a hedge fund called Princeton/Newport Partners.
This hedge fund eventually began to dominate the financial markets, and the approach it pioneered developed into a full-fledged industry unto itself.
Thereafter, a whole new crop of physicists entered a bleak labor market.
Many of them made the transition into finance after seeing the staggering sums of cash that could be earned on Wall Street.
It was also noticed that in Britain, the collapse of the Soviet Union produced an inflow of Warsaw Pact scientists. Therefore, they introduced a new approach based on “analyzing the data” and the knowledge that powerful enough computers may aid in market forecasting.
Due to this, a new approach to quantitative analysis emerged, popularized by the work of a mathematical prodigy called Jim Simons.
Furthermore, Jim Simons established Renaissance Technologies, a leading hedge fund management firm, in 1982.
Altogether, that was the synopsis of “how math gained off in algorithmic trading” and became so successful.
The mathematical ideas behind algorithmic trading are the meat of this piece, so let’s get to them.
Topics in Stock Market Mathematics
Mathematical principles play an essential part in algorithmic trading, and it is vital to note this while discussing the mathematical foundations of stock trading. Let us have a look at the divisions of distinct mathematical notions here:
- Statistical Characterization
- Probability Theory
- Linear Algebra
- Using the Calculus of Linear Regression
- Numbers that Describe