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Inside the Black Box: A Simple Guide to Quantitative and High Frequency Trading, 2nd Edition


High Praise for Inside the Black Box

"Rishi provides a comprehensive overview of quantitative investing that should prove useful both to those allocating money to quant strategies and those interested in becoming quants themselves. Rishi's experience as a well-respected quant Fund of Funds manager and his solid relationships with many practitioners provide ample useful material for his work."
—PETER MULLER, founder, PDT Partners

"Quantitative trading, like all investment strategies, gets more complex yet more interesting the deeper you dig into it. Rishi deftly peels back the layers, walking readers through each building block and their combination, then providing useful chapters on evaluating model-based approaches and finally a new section surveying high-frequency trading. Anyone approaching the space will learn something from this clear, thorough, and readable book."
—ALEKSANDER WEILER, CFA, Senior Portfolio Manager, Public Market Investments, Canada Pension Plan Investment Board

"Rishi continues to demystify even more quantitative trading areas in this excellent new edition. Significant updates include several new chapters that shine much-needed light on high-speed and high-frequency trading. This book continues to be a must-read for anyone interested in quantitative trading."
—STEVE EVANS, Managing Director of Quantitative Trading, Tudor Investment Corporation

"In Inside the Black Box: A Simple Guide to Quantitative and High-Frequency Trading, Rishi Narang demystifies quantitative trading. His explanation and classification of alpha will enlighten even a seasoned veteran."
—BLAIR HULL, former founder of Hull Trading Co. and founder of Ketchum Trading

"In this updated edition, Rishi again provides an insightfultaxonomy of a wide range of systematic trading strategies in liquid instruments. Without the extensive use of complex formulae, this book offers intutitive explanations of some of the choices faced by quants in constructing trading systems, and is a valuable read for investors and quantitative trading practitioners alike."
—ROSS GARON, Managing Director, Quantitative Strategies, SAC Capital Advisors, LP

"Rishi takes a complicated subject and distills it down to its essentials using non-technical language and numerous concrete examples to bring concepts alive. Inside the Black Box provides readers with a valuable framework to understand the various components of quant strategies and insights on how to evaluate and interview quant managers. Inside the Black Box is a useful reference guide for any institutional allocator to quant strategies."
—DAREN SMITH, CFA, CAIA, FSA, Managing Director, Manager Selection & Portfolio Construction, University of Toronto Asset Managment

"If a car were a black box, Rishi would be the gentle voice of the navigation system. Not the one driving, but if you want to know where everyone is going: just listen."
—HAROLD de BOER, CEO, Transtrend

Rishi K. Narang is the Founding Principal of Telesis Capital LLC, which invests in quantitative trading strategies. Previously, he was managing director and co–portfolio manager at Santa Barbara Alpha Strategies. Narang cofounded and was president of Tradeworx, Inc., a quantitative hedge fund manager, from 1999–2002. He has been involved in the hedge fund industry, with a focus on quantitative trading strategies, since 1996. Narang graduated from the University of California, Berkeley, with a BA in economics.

Preface to the Second Edition xiii

Acknowledgments xvii

Part ONE The Quant Universe

Chapter 1 Why Does Quant Trading Matter? 3

The Benefit of Deep Thought 8

The Measurement and Mismeasurement of Risk 9

Disciplined Implementation 10

Summary 11

Notes 11

Chapter 2 An Introduction to Quantitative Trading 13

What Is a Quant? 14

What Is the Typical Structure of a Quantitative Trading System? 16

Summary 19

Notes 20

Part two Inside the Black Box

Chapter 3 Alpha Models: How Quants Make Money 23

Types of Alpha Models: Theory-Driven and Data-Driven 24

Theory-Driven Alpha Models 26

Data-Driven Alpha Models 42

Implementing the Strategies 45

Blending Alpha Models 56

Summary 62

Notes 64

Chapter 4 Risk Models 67

Limiting the Amount of Risk 69

Limiting the Types of Risk 72

Summary 76

Notes 78

Chapter 5 Transaction Cost Models 79

Defining Transaction Costs 80

Types of Transaction Cost Models 85

Summary 90

Note 91

Chapter 6 Portfolio Construction Models 93

Rule-Based Portfolio Construction Models 94

Portfolio Optimizers 98

Output of Portfolio Construction Models 112

How Quants Choose a Portfolio Construction Model 113

Summary 113

Notes 115

Chapter 7 Execution 117

Order Execution Algorithms 119

Trading Infrastructure 128

Summary 130

Notes 131

Chapter 8 Data 133

The Importance of Data 133

Types of Data 135

Sources of Data 137

Cleaning Data 139

Storing Data 144

Summary 145

Notes 146

Chapter 9 Research 147

Blueprint for Research: The Scientific Method 147

Idea Generation 149

Testing 151

Summary 170

Note 171

Part three A Practical Guide for Investors in Quantitative Strategies

Chapter 10 Risks Inherent to Quant Strategies 175

Model Risk 176

Regime Change Risk 180

Exogenous Shock Risk 184

Contagion, or Common Investor, Risk 186

How Quants Monitor Risk 193

Summary 195

Notes 195

Chapter 11 Criticisms of Quant Trading 197

Trading Is an Art, Not a Science 197

Quants Cause More Market Volatility by Underestimating Risk 199

Quants Cannot Handle Unusual Events or Rapid Changes in Market Conditions 204

Quants Are All the Same 206

Only a Few Large Quants Can Thrive in the Long Run 207

Quants Are Guilty of Data Mining 210

Summary 213

Notes 213

Chapter 12 Evaluating Quants and Quant Strategies 215

Gathering Information 216

Evaluating a Quantitative Trading Strategy 218

Evaluating the Acumen of Quantitative Traders 221

The Edge 223

Evaluating Integrity 227

How Quants Fit into a Portfolio 229

Summary 231

Note 233

Part four High-Speed and High-Frequency Trading

Chapter 13 An Introduction to High-Speed and High-Frequency Trading* 237

Notes 241

Chapter 14 High-Speed Trading 243

Why Speed Matters 244

Sources of Latency 252

Summary 262

Notes 263

Chapter 15 High-Frequency Trading 265

Contractual Market Making 265

Noncontractual Market Making 269

Arbitrage 271

Fast Alpha 273

HFT Risk Management and Portfolio Construction 274

Summary 277

Note 277

Chapter 16 Controversy Regarding High-Frequency Trading 279

Does HFT Create Unfair Competition? 280

Does HFT Lead to Front-Running or Market Manipulation? 283

Does HFT Lead to Greater Volatility or Structural Instability? 289

Does HFT Lack Social Value? 296

Regulatory Considerations 297

Summary 299

Notes 300

Chapter 17 Looking to the Future of Quant Trading 303

About the Author 307

Index 309