Equity Valuation and Portfolio Management

DEVELOPING FACTOR-BASED TRADING STRATEGIES

The development of a trading strategy has many similarities with an engineering project. We begin by designing a framework that is flexible enough so that the components can be easily modified, yet structured enough that we remain focused on our end goal of designing a profitable trading strategy.

Basic Framework and Building Blocks

The typical steps in the development of a trading strategy are:

• Defining a trading idea or investment strategy.
• Developing factors.
• Acquiring and processing data.
• Analyzing the factors.
• Building the strategy.
• Evaluating the strategy.
• Backtesting the strategy.
• Implementing the strategy.

In what follows, we take a closer look at each step.

Defining a Trading Idea or Investment Strategy

A successful trading strategy often starts as an idea based on sound economic intuition, market insight, or the discovery of an anomaly. Background research can be helpful in order to understand what others have tried or implemented in the past.

We distinguish between a trading idea and trading strategy based on the underlying economic motivation. A trading idea has a more short-term horizon often associated with an event or mispricing. A trading strategy has a longer horizon and is frequently based on the exploitation of a premium associated with an anomaly or a characteristic.

Developing Factors

Factors provide building blocks of the model used to build an investment strategy. We introduced a general definition of factors earlier ...