What Is Strategy decay?
In quantitative finance, strategy decay means that a trading strategy loses is excessive profit, or alpha generation, capabilities over time.
“Strategy decay is one of the trickiest aspects to manage within the realm of quantitative trading. It involves previously performing strategies that gradually, and sometimes rapidly, lose their performance characteristics and end up becoming unprofitable.”
“Quantitative trading strategies almost unilaterally rely on the concept of forecasting and/or statistical mispricing. As more and more trading entities–retail or institutional–implement similar systematic strategies the mispricings give way to price efficiency. The gain derived from such strategies is eroded and then usually falls to the level of transaction costs required to carry it out, making them unprofitable.”
“This means that quantitative trading is not a “set and forget” activity. In reality quant traders need to have a portfolio of strategies that are slowly rotated out over time once any arbitrage opportunities begin to erode. Thus constant research is required to continually develop new profitable edges that replace those that have been arbed away”.
One common way to measure and visualise strategy decay is visualising rolling Sharpe ratio. If Sharpe is getting worse over time, the strategy is decaying.
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