What is Quantitative Finance? As Wags on Billions once astutely summarized: “Wild guesses, with math!”
Before we dive deeply into the math world that is Quantland, into regressions, covariances, and Sharpe Ratios, I want to step back and tell a little parable that is good to always have in one’s mind as background. Today, I want to specifically ask and answer a question that I honestly wondered about for the longest time. Why are Wall Street traders and hedge fund managers paid so extravagantly and obscenely? What exactly do they do?
The banal answer, of course, in the simplest formulation –before the Era of Derivatives and other “Financial Weapons of Mass Destruction” (as Warren Buffett once coined)– is traders sit behind their trading desks and buy and sell equities all day long. Dear Reader, I know this is difficult to fathom, but there once upon a time existed a world before computers and the internet. Back in these olden days of yore –before options trading, calls, puts, strike prices, and whatnot– it really was just “buy low and sell high.” And while the financial world has obviously exponentially exploded in complexity this past half-century, I want to return to that era when things were simpler to tell today’s parable. Strategies, tactics, and tools may have evolved, coming and going with the times– but the overarching mandate of professional traders who trade for a living have not: They are there to generate as much money as humanly possible for whatever institutions that employ them. Let’s examine this Parable of the Three Traders to illustrate how they do that.
First is Trader John. Trader John’s a humble fellow. He buys into Apple at $50 per share. Over the next few days, Apple goes up and down but Trader John’s a patient man. Finally, after a few weeks, Trader John finally sells at $250 per share. Not bad. Trader John’s made a tidy $200 profit per share.
Next up is Trader Jamie, a little more ambitious fellow. Trader Jamie buys Apple at $50 and sells at $150 a few days later. Apple then plunges back to $50 because our Genius President declares some imaginary Trade War with China, a country in which Apple does huge business. Trader Jamie buys back in at $50 and then rides Apple back all the way up, selling at $250. In total, Trader Jamie walks off with $300 profit per share.
Finally, we’ve got Trader Lloyd –the most brilliant and prescient genius of them all. Trader Lloyd buys Apple at $50. Sells and shorts at $150. Rides the “Apple-China-Trade-War-Plunge” back down to earth and then covers and buys back in at $50. A few weeks later, Trader Lloyd sells at $250. Total tally: Trader Lloyd rides into the sunset on horseback making $400 profit per share.
(For the sake of this parable, we’re assuming Trader John/Jamie/Lloyd all possess X-Men-like abilities to time the market perfectly btw, buying and selling (and shorting and covering) at the precise nadirs and peaks. A feat easier said than done. But you’re certainly welcome to try.)
So what’s the takeaway? Long story short is every single trader on Wall Street is aiming to be Trader Lloyd. Traders want market volatility because that’s how they justify their fat salaries and obscene bonuses. Traders love a chaotic and volatile market where they have tons of opportunities to buy, sell, short, and cover at different price points. And if they’re as smart as they think they are, they’ll be able to time things perfectly netting bajillions of dollars.
So remember this if you’re aspiring to jump in with the sharks: Traders don’t want stocks to make a straight run from A to B. Where’s the fun in that? They want chaos and total mayhem. They want 1,000-point plunges in the Dow. They will look for a reason, any reason, to try to slam the market downwards when things are going well. Likewise, they’ll look for a reason to rocket the market upwards when things are down. A slightly above-average jobs report, a slightly bad earnings report by Apple, anything. If you observe the market long enough, you’ll notice a general “physics” that governs price movement. What goes up, especially if its rise is mercurial, eventually comes crashing back down to earth (I invite you to look up AMD and Apple in 2018). Traders enjoy ranges. When a stock is trading within a range, there’s no easier time to make money.