Inside the Black Box: A Simple Guide to Quantitative and High Frequency Trading

Inside the Black Box: A Simple Guide to Quantitative and High Frequency Trading

by Rishi K. Narang

Hardcover(2nd ed.)

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New edition of book that demystifies quant and algo trading

In this updated edition of his bestselling book, Rishi K Narang offers in a straightforward, nontechnical style—supplemented by real-world examples and informative anecdotes—a reliable resource takes you on a detailed tour through the black box. He skillfully sheds light upon the work that quants do, lifting the veil of mystery around quantitative trading and allowing anyone interested in doing so to understand quants and their strategies. This new edition includes information on High Frequency Trading.

  • Offers an update on the bestselling book for explaining in non-mathematical terms what quant and algo trading are and how they work
  • Provides key information for investors to evaluate the best hedge fund investments
  • Explains how quant strategies fit into a portfolio, why they are valuable, and how to evaluate a quant manager

This new edition of Inside the Black Box explains quant investing without the jargon and goes a long way toward educating investment professionals.

Product Details

ISBN-13: 9781118362419
Publisher: Wiley
Publication date: 03/25/2013
Series: Wiley Finance Series , #846
Edition description: 2nd ed.
Pages: 336
Sales rank: 787,065
Product dimensions: 6.00(w) x 9.10(h) x 0.70(d)

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.

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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

What People are Saying About This

From the Publisher

"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.”

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