Financial Models for trading and investments – Part 1

Let me today give some ideas about financial models or quantitative models that are often used by traders, fund managers as well as individuals across the globe for the purpose of trading and investments.

We all are familiar with SIP or Systematic Investment Plans. That is a kind of Financial model, where we keep on investing at regular intervals of time and try to benefit from the average buy price phenomenon in the long run. This investment strategy works well only in the long run.

However, there are much more complex financial models or mathematical models that are followed in the world of investment and trading.

Most of these models are generated and developed by quantitative financial teams at the investment banks, investment firms and brokerage houses. These teams then test their models on the historical data to see if it works well or not. For the model that works well, it is passed on and explained to the traders of that firm. The traders then use the model to capitalize on the trading strategy or investment strategy and try to make money.

However, one most important thing that we should realize here is that whatever is possible in theory may not be possible in practice. You may see a big price difference in the prices of a cheap stock on NSE and BSE. However, there may be no liquidity for that stock in the market.

Suppose a stock is listed in NASDAQ and NYSE. You observe that the price of that stock on NASDAQ is $2, while on NYSE it is $2.2. Hence, you decide to buy the stock for less at NASDAQ and immediately sell it at NYSE for the high price of 2.2. However, one thing that may go wrong here is that the prices you are observing are the last traded prices. They may no longer be valid by the time you place your 2 trades, and you may end up suffering a loss.

Another problem that may come is for liquidity, as mentioned above. You may observe a big price difference. But there may be no buyers or sellers willing to trade on that stock. So even if you identify a price discrepancy, there is a possibility that PRACTICALLY, your trade may not be profitable as per your trading strategy.

The same thing goes on for investments which are made for long term horizons. Quantitative research teams keep on coming up with financial models that suggest investing for 3, 5 10, 15 or 30 long years. They test the data with the historical data and see if it has worked well in the past. If they identify profitable opportunities, the investment strategy is suggested to fund managers and investors.

Continue to Part II