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Mathematical analysis of financial markets is more celebrated when applied to relative valuation of different assets, rather than prediction of the market. Blac

Mathematical analysis of financial markets is more celebrated when applied to relative valuation of different assets, rather than prediction of the market. Black-scholes, for example, applied calculus with an underlying no-arbitrage assumption to create a thriving market in option pricing, by giving traders a mechanism to reduce risk and thereby reduce bid offer spreads. Same in fixed income, mortgage, and credit market assets over the years. The problem with predicting absolute levels, is that there is a game theoretic aspect which undermines any mathematical trading strategy as soon as it is public. optimal game theory trading strategies don’t produce great results, and they are relatively trivial to identify. Instead strong profits in market long/short macro positions are mostly created by information advantages, which don’t really make for interesting Kaggle competitions. For example, big profits in macro trading have historically been consistently achieved by front running customer orders, by building timing advantages on top of trading infrastructure, by funding research analysts that inspect operations on the ground, by lobbying for regulations that change market directions and so on. It’s very hard to tell if a best performing hedge funds that doesn’t have an unfair advantage, that declares its only using quantitative strategies, is in fact just a statistical anomaly with a hollow narrative.

georgeecollins 6y ago
This! >> The problem with predicting absolute levels, is that there is a game theoretic aspect which undermines any mathematical trading strategy as soon as it is public. I took finance in Business school, coming from doing a lot of statistical analysis in a research lab. I hated my finance professors and there pseudo science. Pricing formulas work great until they don't. The problem is when they don't, they really don't, in a catastrophic way. Read "When Genius Failed." Real traders know this. But some economists and finance professors act like these mathematical models are describing a predictable physical phenomena.
- milesvp 6y ago
  To add to this, unless your model is situated, and can purturb the market, it has no way of knowing what happens when you flex your muscle. I have a friend who did algorithmic trading professionally for a few years, and he said it was amazing to watch the data. Said he could see other bots come along and poke him, trying to look for weaknesses in his algorithm to exploit. I would expect a purely formulaic trader to underperform other traders who can take advantage of others. It’s no different than how you have to win a rhoshambo turnament.
  - jtms 6y ago
    Ok, I’ll bite - how, precisely, does one win a rhoshambo tournament?
- riazrizvi 6y ago
  To clarify, the hedge fund LTCM in "When Genius Failed", collapsed not because it relied on arbitrage 'pricing formulae', rather because it failed to properly execute arbitrage trades. LTCM in being overly leveraged, relied on other market participants to maintain short term price alignment, which meant it was not arbitrage. Salomon's reduced its role as market-maker, maintaining short term price alignment, which increased short term price anomalies, and thus increased LTCM's vulnerability. The Asian financial crisis increased the frequency and extent of those pricing anomalies, and the subsequent Russian Default crisis did the same. Margin calls were made on LTCM that it couldn't cover, forcing them to close out of their positions at very unprofitable times of the trade strategy. So I don't think "pseudo-science" is a great description for what those B-School profs are teaching. Rather the pricing formulae are just the beginnings of the financial theory you need to run arbitrage strategies, but they are not sufficient. You need to augment them with a broader picture of market dynamics and capital management, just like you'd need to learn about financial law, financial market technology, and a bunch of other stuff to run a successful market-making desk.
  - eru 6y ago
    'Why aren't they shouting' also has some things to say about LTCM. Broadly in the same vein. Those guys were leveraged to the gills and couldn't take market movements against them. From what I've read elsewhere, if you had managed to hold an LTCM replica portfolio until expiry, you would have actually made money.
blovescoffee 6y ago
I've wanted to start learning about this for a while but I'm really not sure where to start. I have a degree in CS and Math so I'm not a total layman wrt the maths. Do you have any suggestions?
- riazrizvi 6y ago
  What's your goal?
  - deleted 6y ago
    [deleted]
  - nikbojo 6y ago
    To have fun exploring and learning.
    - partingshots 6y ago
      And also rule the world.
      - andi999 6y ago
        I am not that ambitious, just one or two billion in assets.
  - blovescoffee 6y ago
    Primarily to learn for the sake of the thrill of learning. I would like to have a better understanding of the analytical methods for understanding markets. I'm interested in the application of game theory from more of a beginners point of view but any mathematical tools to understand the world better are interesting to me. I'm not really focused on making money, just interested in better intuition/understanding of economics.
- secondcoming 6y ago
  This might be a good starting point. https://www.wiley.com/en-us/Paul+Wilmott+Introduces+Quantitative+Finance%2C+2nd+Edition-p-9781118836798 https://www.wiley.com/en-us/Paul+Wilmott+Introduces+Quantita...
hogFeast 6y ago
Also, prices aren't stationary. For an equity security, you are predicting the price for a company that is compounding capital over time. You can predict the price for the company at one point, the relative valuation for the company (for example, against peer group) may not change in one year but that company is investing their capital at X% so you get price growth. The reason why relative valuation models are more effective is the same reason why most sports betting models use current odds as an input. Prices contain information but, in my experience, these methods aren't totally effective because they often miss important information about the company itself (big price moves happen because relative valuations are wrong). Value or quality appears to do fundamental work but is often woefully blind (for example, there are proven accounting issues with value strategies...does your average quant understand this? No. Have they ever read a set of accounts? No. They have no hope. None.) Just imo, I think quant strategies are almost totally worthless beyond liquidity provision (even a strategy like front-running news in FX...humans do this better, and I know people who are still making tons of money doing this). I think there is massive value in that mode of analysis but the people who make the most are always going to be people who know the fundamentals better (I think firms like Marshall Wace that are doing this synthesis will move ahead) because that information is often not in the price at all.
- ackbar03 6y ago
  > Also, prices aren't stationary I'm not sure about the rest of your comment, but this is mathematically the correct reason why we don't predict absolute price levels. And the reason why this is mathematically the correct reason is because for a non-stationary process, when you predict into the future, the variance tends to infinity which means taking expectation on any statistical model is useless since the variance is ridiculously wide
amelius 6y ago
> relative valuation of different assets, rather than prediction of the market But isn't prediction an inherent part of valuation?
- harry8 6y ago
  >But isn't prediction an inherent part of valuation? Doesn't need to be. You have wealth you have to store somehwere because it is not being spent now. Can store it as equities, debt (including a bank account), Paper cash money under the mattress, gold bars, BTC, etc etc. Let's say you have the list of potential places to store it and can get a price/value ratio but with a common term of "X" in the value - A = 3.1/X - B = 2.8/X - C = 1.9/X - D = 4.2/X Gotta put it somewhere if you aren't spending it. In the above you'd Choose "C". Lowest price to value ratio even though you don't know what the actual value is. Yes, this is a massive simplification as it ignores diversification benefits and so on but there's the basics of the usefulness of valuation where you don't and can't know the value. "prediction of the market" here means "Do you think the S&P500 is going up or down this year?" Warren Buffet completely ignores this, takes no view on it. Timing the market is very hard. Assuming the market will reflect the economy and the economy will grow because people work hard, are smart, we invent new things and population increases, then picking the best of what's available is the normal value investors route, a la Buffet as the most famous practioner. Burton Malkiel's "A Random Walk Down Wall St." is still, IMHO the best summary of all the theory and practise of investing - excluding the quant funds like Renaissance. Maybe he has an update for them? Maybe it's also worth reading if it exists or maybe not. Don't know. No idea if renaissance time the market or what. edit: punctuation and the Malkiel recommendation.
- arthurcolle 6y ago
  This is highly dependent on the model in question. If you look at the parameters of the Black-Merton-Scholes model, there are assumptions embedded in the model that aren't necessarily predictions.
- riazrizvi 6y ago
  Relative price prediction is an inherent part of valuation. You predict what the price of, say, a bond is given the price of the discount rate over the life of that bond. You are not predicting the absolute price of the bond, you are not able to predict if rates are going to go up or down. That's the appeal of arbitrage, you don't need to see the future, you make money no matter what if you see that a particular asset is 'out of whack', mis-priced, cheap, expensive, and you buy/sell it (and execute the appropriate arbitrage hedging strategy until maturity of the trade).
eru 6y ago
Just as an aside: the kind of prediction you are describing as relatively boring is still really useful, because it improves markets as far as the rest of society is concerned. But yeah, it might not be that useful for the funds themselves.
logicchains 6y ago
>The problem with predicting absolute levels, is that there is a game theoretic aspect which undermines any mathematical trading strategy as soon as it is public. optimal game theory trading strategies don’t produce great results, and they are relatively trivial to identify. This isn't true if you're fast enough. Everybody knows how to do arbitrage but it's still extremely profitable if you're faster than everyone else. HFTs are consistently more profitable than slow trading firms, earning 40%+ returns, it's just a much more capacity-constrained form of trading so absolute returns are lower.

georgeecollins 6y ago

This! >> The problem with predicting absolute levels, is that there is a game theoretic aspect which undermines any mathematical trading strategy as soon as it is public. I took finance in Business school, coming from doing a lot of statistical analysis in a research lab. I hated my finance professors and there pseudo science. Pricing formulas work great until they don't. The problem is when they don't, they really don't, in a catastrophic way. Read "When Genius Failed." Real traders know this. But some economists and finance professors act like these mathematical models are describing a predictable physical phenomena.

milesvp 6y ago
To add to this, unless your model is situated, and can purturb the market, it has no way of knowing what happens when you flex your muscle. I have a friend who did algorithmic trading professionally for a few years, and he said it was amazing to watch the data. Said he could see other bots come along and poke him, trying to look for weaknesses in his algorithm to exploit. I would expect a purely formulaic trader to underperform other traders who can take advantage of others. It’s no different than how you have to win a rhoshambo turnament.
- jtms 6y ago
  Ok, I’ll bite - how, precisely, does one win a rhoshambo tournament?
riazrizvi 6y ago
To clarify, the hedge fund LTCM in "When Genius Failed", collapsed not because it relied on arbitrage 'pricing formulae', rather because it failed to properly execute arbitrage trades. LTCM in being overly leveraged, relied on other market participants to maintain short term price alignment, which meant it was not arbitrage. Salomon's reduced its role as market-maker, maintaining short term price alignment, which increased short term price anomalies, and thus increased LTCM's vulnerability. The Asian financial crisis increased the frequency and extent of those pricing anomalies, and the subsequent Russian Default crisis did the same. Margin calls were made on LTCM that it couldn't cover, forcing them to close out of their positions at very unprofitable times of the trade strategy. So I don't think "pseudo-science" is a great description for what those B-School profs are teaching. Rather the pricing formulae are just the beginnings of the financial theory you need to run arbitrage strategies, but they are not sufficient. You need to augment them with a broader picture of market dynamics and capital management, just like you'd need to learn about financial law, financial market technology, and a bunch of other stuff to run a successful market-making desk.
- eru 6y ago
  'Why aren't they shouting' also has some things to say about LTCM. Broadly in the same vein. Those guys were leveraged to the gills and couldn't take market movements against them. From what I've read elsewhere, if you had managed to hold an LTCM replica portfolio until expiry, you would have actually made money.

blovescoffee 6y ago

I've wanted to start learning about this for a while but I'm really not sure where to start. I have a degree in CS and Math so I'm not a total layman wrt the maths. Do you have any suggestions?

riazrizvi 6y ago
What's your goal?
- deleted 6y ago
  [deleted]
- nikbojo 6y ago
  To have fun exploring and learning.
  - partingshots 6y ago
    And also rule the world.
    - andi999 6y ago
      I am not that ambitious, just one or two billion in assets.
- blovescoffee 6y ago
  Primarily to learn for the sake of the thrill of learning. I would like to have a better understanding of the analytical methods for understanding markets. I'm interested in the application of game theory from more of a beginners point of view but any mathematical tools to understand the world better are interesting to me. I'm not really focused on making money, just interested in better intuition/understanding of economics.
secondcoming 6y ago
This might be a good starting point. https://www.wiley.com/en-us/Paul+Wilmott+Introduces+Quantitative+Finance%2C+2nd+Edition-p-9781118836798 https://www.wiley.com/en-us/Paul+Wilmott+Introduces+Quantita...

hogFeast 6y ago

Also, prices aren't stationary. For an equity security, you are predicting the price for a company that is compounding capital over time. You can predict the price for the company at one point, the relative valuation for the company (for example, against peer group) may not change in one year but that company is investing their capital at X% so you get price growth. The reason why relative valuation models are more effective is the same reason why most sports betting models use current odds as an input. Prices contain information but, in my experience, these methods aren't totally effective because they often miss important information about the company itself (big price moves happen because relative valuations are wrong). Value or quality appears to do fundamental work but is often woefully blind (for example, there are proven accounting issues with value strategies...does your average quant understand this? No. Have they ever read a set of accounts? No. They have no hope. None.) Just imo, I think quant strategies are almost totally worthless beyond liquidity provision (even a strategy like front-running news in FX...humans do this better, and I know people who are still making tons of money doing this). I think there is massive value in that mode of analysis but the people who make the most are always going to be people who know the fundamentals better (I think firms like Marshall Wace that are doing this synthesis will move ahead) because that information is often not in the price at all.

ackbar03 6y ago
> Also, prices aren't stationary I'm not sure about the rest of your comment, but this is mathematically the correct reason why we don't predict absolute price levels. And the reason why this is mathematically the correct reason is because for a non-stationary process, when you predict into the future, the variance tends to infinity which means taking expectation on any statistical model is useless since the variance is ridiculously wide

amelius 6y ago

> relative valuation of different assets, rather than prediction of the market But isn't prediction an inherent part of valuation?

harry8 6y ago
>But isn't prediction an inherent part of valuation? Doesn't need to be. You have wealth you have to store somehwere because it is not being spent now. Can store it as equities, debt (including a bank account), Paper cash money under the mattress, gold bars, BTC, etc etc. Let's say you have the list of potential places to store it and can get a price/value ratio but with a common term of "X" in the value - A = 3.1/X - B = 2.8/X - C = 1.9/X - D = 4.2/X Gotta put it somewhere if you aren't spending it. In the above you'd Choose "C". Lowest price to value ratio even though you don't know what the actual value is. Yes, this is a massive simplification as it ignores diversification benefits and so on but there's the basics of the usefulness of valuation where you don't and can't know the value. "prediction of the market" here means "Do you think the S&P500 is going up or down this year?" Warren Buffet completely ignores this, takes no view on it. Timing the market is very hard. Assuming the market will reflect the economy and the economy will grow because people work hard, are smart, we invent new things and population increases, then picking the best of what's available is the normal value investors route, a la Buffet as the most famous practioner. Burton Malkiel's "A Random Walk Down Wall St." is still, IMHO the best summary of all the theory and practise of investing - excluding the quant funds like Renaissance. Maybe he has an update for them? Maybe it's also worth reading if it exists or maybe not. Don't know. No idea if renaissance time the market or what. edit: punctuation and the Malkiel recommendation.
arthurcolle 6y ago
This is highly dependent on the model in question. If you look at the parameters of the Black-Merton-Scholes model, there are assumptions embedded in the model that aren't necessarily predictions.
riazrizvi 6y ago
Relative price prediction is an inherent part of valuation. You predict what the price of, say, a bond is given the price of the discount rate over the life of that bond. You are not predicting the absolute price of the bond, you are not able to predict if rates are going to go up or down. That's the appeal of arbitrage, you don't need to see the future, you make money no matter what if you see that a particular asset is 'out of whack', mis-priced, cheap, expensive, and you buy/sell it (and execute the appropriate arbitrage hedging strategy until maturity of the trade).

eru 6y ago

Just as an aside: the kind of prediction you are describing as relatively boring is still really useful, because it improves markets as far as the rest of society is concerned. But yeah, it might not be that useful for the funds themselves.

logicchains 6y ago

>The problem with predicting absolute levels, is that there is a game theoretic aspect which undermines any mathematical trading strategy as soon as it is public. optimal game theory trading strategies don’t produce great results, and they are relatively trivial to identify. This isn't true if you're fast enough. Everybody knows how to do arbitrage but it's still extremely profitable if you're faster than everyone else. HFTs are consistently more profitable than slow trading firms, earning 40%+ returns, it's just a much more capacity-constrained form of trading so absolute returns are lower.