Quantitative Trading: CNBC Explains

Erik Snyder | Lifesize | Getty Images

Investors have a lot of tools and strategies to use when it comes to playing the market. One of them is called quantitative trading. So how does it work? CNBC explains.

What is quantitative trading?

In Wall Street lingo, it's a technical investment strategy that relies on mathematical formulas and computations to recognize investing opportunities.

In plain English, it's a computer-based system that tracks what's going on with a stock in order to buy or sell at the 'right price.'

How does it work?

Quantitative trading strategy uses computer software programs and spreadsheets to track patterns or trends in a stock or stocks. These trends come from the price of the stock and the volume or frequency at which it is traded.

Stocks usually trade in upward and downward cycles and quantitative trading aims to capitalize on those trends.

The objective behind quantitative trading is to find investment opportunities in under-priced securities and/or to find assets that are over-priced.

Quantitative trading takes much of the human element out of investment decisions. The reasoning behind it is that some 'behaviors' in a stock might be missed by people, where a computer program might pick it up.

It's a big alternative to qualitative trading—which is an investment technique based on financial experts' insight and analysis. But it's not completely devoid of the human touch, as we'll see below.

When did quantitative trading start?

Quantitative trading really got started in the U.S. in the 1970s. That's when some investors began using mathematical formulas to price stocks and bonds.

They were basing their efforts on the 1952 research thesis by Nobel Prize winner Harry Markowitz, one of the first papers to formally adapt mathematical concepts to finance. Markowitz showed how to compute the average return and variables for a given stock portfolio.

It's important to note that after the 2008 financial crisis, quantitative trading came under heavy criticismthat the computer methods used were not accurate enough when it came to buying and selling stocks and that lead to a big sell-off in the markets.

Efforts to improve the quantitative methods have been investigated.

Who uses quantitative trading?

It's used mostly by hedge funds and mutual funds, who have the resources and technical know-how.

By relying on mathematical formulas, an investment adviser might be better able to see weaknesses in a portfolio that could lead to potential losses if left alone.

For instance. when the price of a stock begins showing signs of entering a trend period based on historical patterns, an investment opportunity might be spotted.

There are cost benefits tied to quantitative trading. Investment advisers often diversify across multiple securities in different regions. A quantitative trading style is designed to reduce the cost of buying and selling many securities in various transactions by streamlining those trades.

What is a quantitative analyst and what is a quant?

A quantitative analyst is a person who works in finance using numerical or quantitative techniques such as quantitative trading.

And a quant is a person who performs quantitative analysis.

What part do humans play in quantitative trading?

The information still has to be analyzed. This is where the quant, mentioned above, begins work. They have to sort through all the data collected to decide whether they have spotted a trend and to determine if there is a sell or buy point.

And that's not all. They might start the process by developing computer software to find pricing, hedging, and risk-managing.