Conversation with a hedge fund trader…and how computers run the economy

Plus some interesting insights on black box trading…

n+1

n+1: And so the computers themselves are making these trades?
HFM: You build the models and the computer does the trading. You actually do all the analysis. But it’s too many stocks for a human brain to handle, so it’s really just guys with a lot of physics and hardcore statistics backgrounds who come up with ideas about models that might lead to excess return and then they test them and then basically all these models get incorporated into a bigger system that trades stocks in an automated way.
n+1: So the computers are running the…
HFM: Yeah, the computer is sending out the orders and doing the trading.
n+1: It’s just a couple steps from that to the computers enslaving— HFM: Yes, but I for one welcome our computer trading masters. People actually call it “black box trading,” because sometimes you don’t even know why the black box is doing what it’s doing, because the whole idea is that if you could, you should be doing it yourself. But it’s something that’s done on such a big scale, a universe of several thousand stocks, that a human brain can’t do it in real time. The problem is that the DNA of a lot of these models is very, very similar, it’s like an ecosystem with no biodiversity because most of the people who do stat-arb can trace their lineage, their intellectual lineage, back to four or five guys who really started the whole black box trading discipline in the ’70s and ’80s. And what happened is, in August, a few of these funds that have big black box trading books suffered losses in other businesses and they decided to reduce risk, so they basically dialed down the black box system. So the black box system started unwinding its positions, and every black box is so similar that everybody was kind of long the same stocks and short the same stocks. So when one fund starts selling off its longs and buying back its shorts, that causes losses for the next black box and the people who run that black box say, “Oh gosh! I’m losing a lot more money than I thought I could. My risk model is no longer relevant; let me turn down my black box.” And basically what you had was an avalanche where everybody’s black box is being shut off, causing incredibly bizarre behavior in the market.
n+1: By the black boxes?
HFM: Well, in the part of the profit-and-loss that they were generating to the point where, to give you an example from our black box system, because we have one…
n+1: A big black box?
HFM: Actually I think it’s gray, and it’s not in our main office, it’s off-site. And we made sure it has no arms or legs or anything it could use to enslave us. But we had a loss over the course of like three days that was like a ten-sigma event, meaning, you know, it should never happen based on the statistical models that underlie it. Why? Because the model doesn’t assume that everybody else is trading the same model as you are. So that’s sort of like a meta-model factor. The model doesn’t know that there are other black boxes out there.

January 21, 2008 · Filed Under Analysis, Business, Interesting tidbits

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