Saturday, May 29, 2010

The Quants

Once in a while, a book about trading written for the general public contains some useful nuggets even for professionals.  Fortune's Formula was one. It introduced me to the world of Kelly's formula, Universal Portfolios, and the maximization of compounded growth rate. The Quants, by WSJ reporter Scott Patterson, is another. (Hat tip to my partner Steve for telling me about it.)

What is the most important take-away in The Quants? No, it is not that you should learn to become a master poker player or chess player before hoping to make it big, though you would think that given Patterson's exhaustive coverage of poker games played by the top quants. Among my own professional acquaintances, trader-poker-players are still a minority.

The most important take-away is what ex-employees said about Renaissance Technologies: "there is no secret formula for the fund's success, no magic code discovered decades ago by geniuses .... Rather, Madallion [Fund]'s team of ninety or so Ph.D.'s are constantly working to improve the fund's systems, ..."

In other words, though you may not have 90 Ph.D.'s  at your disposal, you can still work on continuously improving/refining your strategies, improving the engineering of your trading environment, and increasing the diversity of your strategies. And though you may still not archive 60-70% annualized returns every year, you will nevertheless enjoy stable returns year after year.

By the way, it is good to see my ex-colleagues Lalit Bahl, Vincent and Stephen Della Pietra mentioned in the book, all of whom left IBM to join Renaissance many years ago, and who are extraordinarily nice and friendly guys, quite in contrast to the norm on Wall Street.

22 comments:

Penn State Clips said...

I really liked Fortune's Formula.

My big take-away from The Quants is that it's dangerous to have too much faith in one's models. It must be tempered with common sense and trading experience.

Nizar said...

Fortune's Formula was a great read.
Before that, I'd never heard of Ed Thorpe. Now, I'm his biggest fan.

I've just finished the Quants yesterday. I've always had big respect for Griffin. But to be honest Weinstein and Muller I've never heard of. Maybe because they don't run standalone funds.

With any major blow-up its always the same two factors involved. Leverage and a black swan. And yes it can happen to non Quants also.

Was Brian Hunter a quant?

Ernie Chan said...

Nizar,
I would say that Brian Hunter relies on other quant's analysis to trade, though he himself may not be a quant.
Ernie

Anonymous said...

Ernie,
If you knew that a certain instrument was firmly range-bound between two values, say 1.00 to 1.50, but highly unpredictable within the range (i.e. not necessarily showing any reversion to the midpoint), how would you trade it?
NSP

Ernie Chan said...

NSP,
I would short the instrument when it is near 1.5 and buy it when it is near 1.
Ernie

Steve said...

Ernie,
here's a nice documentary on Quants.
http://zentrader.ca/blog/?p=2543

Enjoy,

Steve

Anonymous said...

Hi Ernie

From reading your site I see you like to measure cointegration over at least a year's period.

How often do you like re-run (or recalibrate) your regressions to calculate the beta's between the stocks?

Anthony

Ernie Chan said...

Hi Anthony,
Why not do the regression every day?
Ernie

Anonymous said...

Hi Ernie, I found this blog so interesting that I’ve ordered your book. However, I would like to ask you a question in advance. I’ve read that the number of shares that you buy/sell is the result of the co-integration analysis that you perform with Matlab. Can you please explain to me what the criterion behind this number is?

Thanks

Mariano

Anonymous said...

Hi Ernie, I found this blog so interesting that I’ve ordered your book. However, I would like to ask you a question in advance. I’ve read that the number of shares that you buy/sell is the result of the co-integration analysis that you perform with Matlab. Can you please explain to me what the criterion behind this number is?

Anonymous said...

Really good book. One thing I've noticed as a trader is that markets change their 'mode' of behavior. What this book shows is that often many, if not all, tend to change their mode at the same time. So one day all your systems might work then the next none of them do.

Windsurfing Stew

Chris Sutherland said...

Hi Mr Chan,

I noticed you'll be giving a course in the UK on June 22nd/23rd.

http://www.technicalanalyst.co.uk/training/trainers/ernest-chan.htm

Just wondering if you'll be video taping or making course material available for purchase after the course?

Thanks,

Chris
chris dot sutherland at g mail

Ernie Chan said...

Hi Mariano,
The hedge ratio is determined by regression between the prices. Cointegration test merely establishes that a pair based on this hedge ratio will be stationary.
Ernie

Ernie Chan said...

Hi Chris,
Yes, I will be teaching a backtesting workshop in London, June 22-23. There will also be a pairs trading workshop in New York in October, and perhaps one in Hong Kong in November/December. Unfortunately, the course material is only available to the attendees, but I will see if we can have a workshop in Toronto in the future.
Ernie

Anonymous said...

Ernie, thanks for your reply. Could you give me an example to get a better sense about the hedge ratio?

Thanks in advance

Mariano

Ernie Chan said...

Mariano,
You can read Example 3.6 in my book to find the complete calculation of hedge ratio.
Ernie

Anonymous said...

Hi Ernie

Do you have any views on using options rather than long/shorting stock?

For example if using options would you still do your cointegration test on the underlying stock prices rather than the option prices?

With options we can have the issue of high implied volatility (IV), so if going long an option with high IV the price movement may not be significant depending on where we are in the option decay timeframe. Do you have a thought on how this can be managed given we are looking to capture profit from the option price change as the underlying stock prices converge?

Regards


John

Ernie Chan said...

Hi John,
I don't see the advantage of implementing this pair trade with options instead of stocks. Besides the difficulty in predicting volatility changes, there is the issue of bid-ask spread of options causing large transaction costs.
Ernie

Anonymous said...

Hi Ernie

What kind of risk free rate do you use? And Where do you get it?

Thank you,
George

Ernie Chan said...

Hi George,
Risk free rate can be obtained here:
http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Either 1-month or 3-month would be appropriate.
Ernie

Max Hu said...

Ernie

This book mentioned Aaron Brown,who is a notable quant as well as poker player.

In his review on book Inside the Black Box: The Simple Truth About Quantitative Trading,he said "The book makes a mess of the distinction between Alpha, which is earned from other active traders, and Beta, which is earned from buy-and-hold investors. What he calls 'theory' in a strategy is no more than ad hoc marketing junk. Theory does not mean just saying you exploit a 'documented behavioral bias' or 'institutional rigidity.' It means a real, sensible, testable theory of who is losing the money you're making. You need to know who those people are, why they are doing it and monitor that they keep doing it.".

This confused me a lot. How can we tell who is losing the money we are making since trading is anonymous? is that possible to diffrentiate and monitor the losers? moreover, aaron said that alpha is from other active traders and beta from buy-and hold. so, is mean-reversion an alpha strategy or beta strategy? Or Maybe he means something else? I'd like to see your comments.

Ernie Chan said...

Max,
In some cases, it is possible to form a theory on why your strategy is profitable, but a definitive proof or evidence will be hard to come by.

Theories are most often formed on seasonal trading strategies.
For e.g. in a previous blog post I discussed why gold prices typically go up before February, and then decreases afterwards relative to platinum prices, based on jewelery purchases in China and India during their holiday seasons.

Also, end-of-year sell-off of losing stocks may be attributed to tax reasons.

Most mean-reverting strategies can be attributed to the action of large long-only investors who demand lots of instant liquidity for their own private reasons.

For more theories of why some strategies work, read the book "Trading and Exchanges" on my Recommended Books list on the right sidebar of this blog.

Mean-reverting strategies are indeed alpha, not beta, simply because we can both long and short. A short position is usually of opposite sign to the beta of an instrument.

Ernie