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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

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.

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.