## Algorithm design and correctness

Giving software you wrote access to your or your firm’s cash account is a scary thing. Making a mistake when manually executing a trade is bad enough when it happens (you can take my word for it if you haven’t yet), but when unintended transactions are made by a piece of software in a tight loop it has the potential to be an extinction event. In other words, there is no faster way to self-immolate than to have incorrect software interacting with markets. It is obvious that correctness is a critical part of the design of an algorithm. How does one go about ensuring1 it then?

Abstractly, a trading algorithm is simply a set of specific actions to be taken depending on the state of things. That state can be internal to the algorithm itself (such has open position, working orders etc.) or associated to the external world (current/historical market state, cash balance, risk parameters etc.). It is then natural for me to think of them as finite state machines (FSM). That presents a couple immediate advantages. FSMs are a very well-studied abstraction in the computer science world, there is then no need to reinvent the wheel as best practices are well accepted. Since they are so often used, just about certain that you will be able to find examples of FSMs implemented for you language of choice. For instance, on the Python Package Index a search for “finite state machine” returns over 100 different frameworks. I am confident the results would be similar for just about any modern language. That being said, let’s backup before we dive deeper on some application of the pattern.

Per Wikipedia, a FSM is an abstract machine that can be in exactly one of a finite number of states at any given time. The FSM can change from one state to another in response to some external inputs; the change from one state to another is called a transition. A FSM is defined by a list of its states, its initial state, and the conditions for each transition. We will use the Turtle trading system 2 rules as an example. The rules are summarized below:

Entry: Go long (short) when the price crosses above (below) the high (low) of the preceding 55 days.
Exit: Cover long (short) when the price crosses below (above) the low (high) of the preceding 20 days.

As we learned previously, to fully define a FSM we need a list of its states, its initial state and the conditions for each transitions. We then have to convert these trading rules to a proper FSM definition.

From the rules above I would define the following trading states: $TradingState\in\left\{Init,Long,Short,StopFromLong,StopFromShort\right\}$ In addition the trading state, the following states would be defined as well as they are relevant to the strategy: $IndicatorStatues\in\left\{Initializing,Ready\right\}$ and finally $(Low50, Low20, High50, High20)\in\mathbb{R}^{4}$. That is to say then that the state space of our algorithm is defined by the following triplet $\left\{TradingState,IndicatorStatus,\mathbb{R}^{4}\right\}$

If you can forgive my abuse of notation, the following outlines the state transitions and their respective conditions:

$\begin{cases} Init\rightarrow Init & IndicatorStatus=Initializing \\Init\rightarrow Long & IndicatorStatus=Ready\land Prc_{t}>High50_{t} \\Init\rightarrow Short & IndicatorStatus=Ready\land Prc_{t}High50_{t} \\Short\rightarrow Short & Prc_{t}\le High20_{t} \\Short\rightarrow SFL & \emptyset \\Short\rightarrow SFS & High20_{t}High50_{t} \\SFL\rightarrow Short & Prc_{t}High50_{t} \\SFS\rightarrow Short & Prc_{t}

Knowing the possible state transitions, we can determine what trading actions are needed in each instance:

$\begin{cases} Init\rightarrow Init & \emptyset \\Init\rightarrow Long & Send\ buy\ order\ for\ N\ units \\Init\rightarrow Short & Send\ sell\ order\ for\ N\ units \\Init\rightarrow SFL & \emptyset \\Init\rightarrow SFS & \emptyset \\ \\Long\rightarrow Init & \emptyset \\Long\rightarrow Long & \emptyset \\Long\rightarrow Short & Send\ sell\ order\ for\ 2N\ units \\Long\rightarrow SFL & Send\ sell\ order\ for\ N\ units \\Long\rightarrow SFS & \emptyset \\ \\Short\rightarrow Init & \emptyset \\Short\rightarrow Long & Send\ buy\ order\ for\ 2N\ units \\Short\rightarrow Short & \emptyset \\Short\rightarrow SFL & \emptyset \\Short\rightarrow SFS & Send\ buy\ order\ for\ N\ units \\ \\SFL\rightarrow Init & \emptyset \\SFL\rightarrow Long & Send\ buy\ order\ for\ N\ units \\SFL\rightarrow Short & Send\ sell\ order\ for\ N\ units \\SFL\rightarrow SFL & \emptyset \\SFL\rightarrow SFS & \emptyset \\ \\SFS\rightarrow Init & \emptyset \\SFS\rightarrow Long & Send\ buy\ order\ for\ N\ units \\SFS\rightarrow Short & Send\ sell\ order\ for\ N\ units \\SFS\rightarrow SFL & \emptyset \\SFS\rightarrow SFS & \emptyset \end{cases}$

This is obviously a simplistic example meant to illustrate my point but lets consider the design for a moment. First it is obvious that each state is mutually exclusive which is a prerequisite for a valid FSM. That in plain terms means that at any point in time I can evaluate the state and figure out clearly what the algorithm was trying to do since there can only be one possible transition given the state at that specific point in time. That would not have been the case had I decided to define the following transition:

$\begin{cases} \cdots \\Long\rightarrow Short & Prc_{t}

In that case, it would be possible for both the conditions to evaluate true and therefore there are more than one possible state transitions. How would you know looking at the logs what this algorithm tried to do? In this case it is again obvious but in more complex FSM I always find it worth the time to carefully consider the entire state space and clearly define the algorithm behavior in a similar fashion to the above. This might seem very long winded but it is something I do on paper religiously before I ever write a line of production code.

The same pattern can also be used in other parts of your trading stack. For instance, your order management system could define orders as a FSM with the following states: $\left\{Sent, Working, Rejected, CxlRequested, Cancelled, CxlRejected, PartiallyFilled, FullyFilled\right\}$. The transitions in this case will have to do with the reception of exchange order events such as acknowledgement, reject messages etc. If you stop to think about it, you could design a whole trading stack with almost nothing but FSMs. By using FSMs you can design to insure correctness of your algorithms and eliminate a whole class of potential design flaws that might sneak in otherwise.

The pattern fits nicely in object-oriented design where state and related behaviors can be grouped in nicely decoupled classes. That said, some functional languages provide you a type system that can provide you with additional guarantees when used properly and can help you build some very powerful abstractions. We will examine an example in  a following post. In the meantime, I would be very interested, as always, to hear which patterns you have found useful in your work.

1. [Or as close as one can get to certainty anyway!]

## 60% of the time, it works every time.

The blogosphere is a very interesting microcosm of the trading world. Many of my older readers will no doubt remember the glory days of “short-term mean-reversion”. By which I mean of course the multitude of posts (including several from yours truly), about RSI2, DV2 and the like. Around 2010 this type of strategy was quite successful and many people put their twist on it posting their results.

Then while this humble publication went into hibernation the collective brain trust of the community turned to the relatively new volatility ETF space. It was glorious; backtests were run, strategies were tweaked, whole websites tracking the strategies popped up and simulated equity curves went to the moon. Life was great. Then on Monday 2018-02-05 the music didn’t just slow down, it stopped. $XIV, the workhorse of many such strategies, there is no nice way to say this; blew up. From what I can see, its demise was met with mixed emotions. Twitter traders with$0.00 AUM knew it all along and were obviously already short $XIV from the high for size. People with subscription strategies either patted themselves on the back for side-stepping the reaper this time, or went AWOL to avoid having to take ownership for the losses incurred by their subscribers. My personal favorite are people selling strategies that usually held$XIV shares as their de-factor short-volatility security declaring that its demise is a non-issue; \$UVXY will do the trick just as well!

This demonstrate such a blatant lack of trading IQ I struggle to put into words. The idea that because it was side-stepped this time the next face-ripping event will as well is simply preposterous. Selling volatility is something you do with other people’s money. It’s a great business, you pocket the recurring fees and performance incentives and when the music stop and you lose your client’s money they take all the loss. As Ron burgundy would put it, 60% of the time, it works every time. We would all be so lucky to find such asymmetric payoff propositions for ourselves, I share in the wins now, you get the blowout later, thanks for playing.

The vast majority of such systems I have encountered in the blogosphere were based on term structure signals to determine whether long or short volatility exposure has tailwind. In this particular instance, thankfully for some, the signal to get out of the short happened before the spike. Why should it do that next time, or the time after that?

I’d love to hear your thinking on the subject, esteemed reader. I know short volatility is a popular trade and has been for some time. Are you still going to do it? Are you worried about events such as the one form this past couple days being an issue in the future? Do you want to pay me a monthly fee for putting you in a trade that has an expected value of 0?

I would be down with that if I could sleep at night knowing you take all the risk and I will be the only one left with any profits to show for when the chips land at the end. Unfortunately, I could not live with myself. For those interested, you can look on collective2 but make sure you filter the strategies by performance excluding this week.