Quants Without Stops

The NY Times had another article about math wizards and their trading efforts on Wall St.  It is such a comforting idea that genius can overcome randomness.  All you need is brains and you’ll find anomalies galore that will give Madoff style returns forever.

Alas, there’s a catch.  If the law of large numbers leads to an anomaly – a 2 or 3 standard deviation from the norm then they drool and put the trade on, believing that at some point normalcy will return.  If it deviates further then they just add to the trade.

The question then becomes: At what point do they decide that this time is truly different and exit the position?  This is the same question you should be asking the portfolio manager you have hired for your stock portfolio.  The answer is usually either:

  1. We can hold the position to expiry or maturity if we have to .. or
  2. The trade is so juicy that we have put it on in huge size so we can’t exit on weakness ; the market isn’t that liquid.

A quant suffers from the same mentality as a fundamental small cap. stock manager – the more a position goes against them the more they like it.

In all cases there must be stop loss levels attached to every trade and a mechanism must exist so they don’t immediately re-enter the position.  Usually this means the positions can’t get too big which is why hiring a manager with huge assets can be a huge mistake.

If you look at the AIG, Citibank, Merrill Lynch problems ,they all can be explained by this simple problem.  They had no stops, they were too big in every trade and they had no mechanism to keep them from always seeing value as the assets’ prices fell .

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