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Inside the Black Box, Second Edition
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Table of Contents

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

About the Author

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.

Reviews

"Rishi Narang breaks down the complexities of quantitative investing into straightforward concepts that are accessible to a wide audience of investors, not just 'math types.' But Inside the Black Box does more than that?it provides a valuable framework for assessing any investment strategy. It's well worth reading regardless of experience level or numerical acumen." ?CRAIG DANDURAND, Portfolio Manager?Absolute Return Strategies, California Public Employees' Retirement System (CalPERS) "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 insightful taxonomy of a wide range of systematic trading strategies in liquid instruments. Without the extensive use of complex formulae, this book offers intuitive 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 presents a thorough overview of quant trading in an easy-to-read format, free of much of the hype and hysteria that has recently surrounded computerized trading. The book clearly categorizes the different types of strategies, explaining in plain English the basic ideas behind how and when they work. Most importantly, it dispels the popular notion that all quants are the same, exposing the diversity of the types of skills and thinking that are involved in quant trading and related disciplines. An excellent read for anyone who wants to understand what the field is all about." ?Shakil Ahmed, PhD, Global Head of Market Making, Citi Equities "To look at the man, you would never know that Rishi could write so clearly and effectively about something as complex as quantitative trading and investment. But he does and does it brilliantly. And, even if you already own the first edition, you should buy this one, too. The new material on high speed trading is worth the price of admission, and you will have a chance, especially in Chapter 16, to see Rishi at his incisive and high spirited best. If you don't laugh out loud, you have no soul." ?Galen Burghardt, Director of Research, Newedge "Quant managers will find their meetings with investors to be smoother if the investors have read this book. And even more so if the manager him or herself has read and understood it." ?David DeMers, Portfolio Manager, SAC Capital Advisors, LP "In this second edition of Inside the Black Box Rishi highlights role of quant trading in recent financial crises with clear language and without using any complex equations. In chapter 11 he addresses common quant myths. He leads us effortlessly through the quant trading processes and makes it very easy to comprehend, as he himself is a quant trader." ?Pankaj N. Patel, Global Head of Quantitative Equity Research, Credit Suisse ?Something that every trader should aspire to, whether his eventual trading box is black or translucent. In brief, this book is not just for those who want to know what quants do (though it does an excellent job of describing their role in the investment community) but for everyone whose trading is informed by more than dart throwing or gut reactions. ? The text is highly readable. No math is required, only, I would suggest, an interest in scientific inquiry and a curiosity about the world that the mathematical elite inhabit. Inside the Black Box is an enlightening and potentially enriching read.? ?Investing.com

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