Quantitative Trading, By Ernest P. Chan: An Extremely Useful Book

by: Nick Gogerty

Quantitativetrading

Quantitative Trading, Ernest P. Chan’s new book on trading, is extremely useful for asset allocators, portfolio managers and traders. They should be doing the same thing: maximizing terminal wealth.

The path and tools chosen varies among the participants. The important thing is to understand what role a person plays and what the processes and tools are for being most effective in that role.

In his book, Ernest P. Chan offers techniques and recipes in Matlab and Excel VBA for the trader wishing to learn more about strategies such as co-integration, money management, back testing, mean reverting and momentum strategies etc. Chan has broad experience with tools and techniques for various strategies and explains things clearly with the voice of an experienced practitioner.

Some of the most important work Chan offers in his book has to do with tying the trade or position level and its potential role in a long term portfolio context.

Many traders and asset managers think in terms of dollars or percentage of portfolio at risk. Many trade with rules of thumb but may not have studied how to maximize the terminal wealth of their strategies and approaches.

The Sharpe ratio is the standard risk metric that most allocators and analysts use to assess a manager or trading system's performance. The Sharpe ratio is typically shown as the annual rate of return minus the risk free rate divided by the annualized standard deviation. This metric is a simple way to measure risk vs. return.

Many gamblers are familiar with card counting and betting strategies based on the odds of the game they are playing. Years ago a formula was derived called the Kelly formula for optimizing the return on a given strategy over the long run.
Transactionpyramid

For example, let's say you play a coin toss game that pays you 101% of your bet each time heads comes up and costs you 100% each time tails come up. How much of your “portfolio” should you wager each time to maximize the returns with this game over the long run? The Kelly formula answers that question.

The transaction pyramid above shows the activity levels of various practitioners. All of them can learn a little thinking about the Kelly and Sharpe Ratio relationship. Whether gambler or student of high finance, it is one of the keys to terminal wealth maximization. I recently created a free spreadsheet tool for exploring this relationship based on Chan's work.

Chan comes up with a simple solution for asset allocators wishing to maximize terminal wealth using Sharpe ratios. With any trading system or allocation approach caveat emptor. Investing in fundamentals with a margin of safety that skews the odds in your favor may be a better approach for portfolio managers.

Assetstotrades

For the asset allocator converting the Sharpe ratio into a single asset allocation % may be an interesting starting point in allocations, but macroeconomic issues are probably more important than variance assumptions given the time horizons and principal return factors involved.

The correct application of the Sharpe to Kelly relations is usually to apply a “sub-optimal” allocation to arrive at a margin of safety. Sub-optimal allocations are chosen as portfolio level assumptions of correlation and co-variance are unstable, this is referred to as a fractional Kelly implementation. These days sub-optimal means an increased Cash or a high cash proxy. Please choose your currency carefully, risk free isn't risk free anymore. My bias is for the Norwegian Krone for the next 2-3 years.

I would highly recommend Chan’s book for the fundamental, technical or quant trader. Chan is concise and clear in teaching the basic methods and tools for a quant. You can visit Chan's excellent blog to get an idea of his thought processes.

For the fundamental portfolio manager, simple factor based analysis may help provide a piece to the puzzle about cyclical influences. My personal interests are studying inter-market company level competitive dynamics and likely moat variance over time. This is probably due to my anthropology background.

I consider economics and markets as nothing more than simple group behavior pursuing individual interests. These groups and individuals are capable of collective myopia and flawed beliefs due to ritualized knowledge and codified social structures. Watching an economy from the outside like a field researcher can be fascinating and lucrative.

One just sits and waits for knowledge to be ritualized to the point where it isn't questioned and then take the opposite position. Ritualized knowledge can be in the form of structures such as flawed systems like ratings agencies or Mean Variance risk tools. False ritualized knowledge can also be in the form of aggregate memes such as house prices can't go down, we are in the 7th inning of the economic storm etc. These narratives become group myopic beliefs leading to blindness and flawed group behaviours. The chain of logic that generated the meme is collapsed into an oft repeated truism which ultimately proves false.

CNBC is the meme machine of American casino capitalism. When it goes off air in 6-8 quarters, it may be time to buy equities again. The silence will be golden. The ratio of octoboxes and decaboxes to viewers must be sliding. The more CNBC screams and rants the fewer people care to listen. There is some good stuff on CNBC, but the needles are getting lost in ever more haystack.

Both fundamental and technical trading and allocation approaches have merit when used as part of a long term process.

The opportunity to learn yet another approach to asset allocation such as the trading techniques illuminated by Chan, even if not pursued help one think in yet another frame. Cognitive code switching in linguistics is related to intelligence. I should like to think multiple analytical framework application is the tool for maximizing terminal wealth at the individual and collective levels.