The History of Mathematics in Algorithmic Trading

Algorithmic trading is all about some simple mathematics. Any logic can be converted into a mathematical expression and orders are placed whenever the expression is TRUE or FALSE. The Logic is what people call an ALGORITHM. And as said in a post earlier, this is one of the methods to trade in a disciplined manner.

The use of mathematics to execute trades started off slowly in the stock markets over a period of almost 50 years, slowly increasing with the advancement of technology, more specifically, computational powers.

The one common anecdote that brought the financial world to revolutionary cross-roads was the invention of computers. The world of mathematics and finance achieved turning grounds with the new computing systems that changed the way the world calculated. The reason algorithm-trading came into existence finds its origins in the formulation of the medium of ‘data analyses.’ With data came exposure to the nuances of the field, the new possibilities and the new talent which came our way.

This is a post to highlight individuals that have a great impact on algorithmic trading and their contributions were what the building blocks of algorithmic trading today.

Edward O. Thorp

Noted for: One of the first ones to apply mathematics for trading

They said sooner or later the casino always wins! But the most groundbreaking attack mounted was made by a player who used only his wits changing the way the world saw gambling. The year, 1959, Ed Thorp, an ambitious young Ph.D. in math headed for a top teaching job at MIT. An idea of fun-time for Thorp is staying up late crunching numbers and calculating the odds on everything. Suddenly, he comes across an article talking about a betting strategy for blackjack and decides to give in to the ‘calculated’ lure of the simplicity of a hit.

Intrigued by the challenge, because mathematicians had spent around 300 years, studying and analyzing gambling unable to find a single way to beat any of the major gambling games. So, on his trip to Vegas, he bets 10 dollars, i.e., all he could afford. Playing applying the ‘basic strategy,’ as math defied his intuition. He recognized that with blackjack the odds change as you play the game. Finding a comprehensive blackjack strategy, solved by compressing enormous data trying to evaluate all the odds, Thorp turns the tables on the dealers. His, published work on the matter fetches him the honor of being called ‘Professor Blackjack,’ a name that changed Thorp’s life and with it the History of Blackjack.

Eugene Fama

Noted for: Efficient Market Hypothesis

He began in an age when Finance had no defined meaning, no paradigms; it basically did not exist. So, anything you did during the 50’s appeared new, “it was like shooting a fish in a barrel.” A toy is where the journey began, with computers came along with the data analysis, a revelation to the statisticians. As long as the algorithm was correct, everything came through the very next day. Suddenly, the mathematicians and the statisticians were released from the burden of calculations, they pounced onto the most easily available data which was stock prices, and that is where the great revolution in the finance industry found its roots.

The most accessible data was securities data, and the only approach was how much could be learned, what could be found. The ‘asset principle,’ ‘the market equilibrium’ is a part of the project, which came through by default. It was never about the hypothesis but about the arithmetic truth. The arithmetic of ‘active management’ is what, was the toughest part to swallow; that 2+2 is 4. Proving this made the industry achieve its Nobel Laureate Eugene Fama, who took the risk of bringing together science and finance.

Warren Buffett

Noted for: Value Investing

The Oracle of Omaha, the sage of Nebraska predicted at the age of ten that he was going to make it big. And 70 years later he is the tycoon as we know him. He began at the age of 9, constantly keeping track of all the stock market charts. With the uncanny ability to remember all the numbers and the pattern on which they stood, this was the skill that became a touchstone to his success. Growing during the ‘Great Depression’ got him into several ventures collecting enough money to invest in his first stock ‘cities service,’ buying three shares.

With better times came better opportunities and with his eidetic memory, he began his own business at the age of 20. He picked stocks that others ignored, and armed with Graham’s theory, he knew what to buy and when. During this time DOW rose by 74%, while Buffett’s investment grew to 250%. So, by 1961, at the age of 30, he was a millionaire. Never looking back, he has been known as the most reliable man, the go-to-guy in the industry.

James Harris  Simons

The NSA came calling to him around the Vietnam War, as they had an operation under development at Princeton where they hired mathematicians to crack secret codes. He accepted the opportunity due to the lucrative offer is presented. But, soon after he got fired because in a general letter he gave his opinion on the war which differed from his bosses and getting published in the Times did not help the cause very much.

Building Renaissance Technologies successfully stands to solve the premise where they were able to achieve high returns with surprisingly low volatility and risk factor at hedge funds. Foreseeing a pattern in the stock numbers, he decided to approach the market through figuring out the ‘market anomalies.’ Bringing together people from multiple fields, mathematicians to astronomers and physicists; science in the field of mathematics has brought about achieving the ‘ALPHA’s’ among the anomalies.

George Soros

Noted for: Known as The Man Who Broke The Bank of England and one of the most successful investors of all times

The man who became the reason for jolting the European Union into a state of panic. The bank of England on this day lost billions and was lead into the biggest financial crisis of history making the speculators ‘Richie rich, rich’. A day of disaster from which the government never recovered, the day of biggest ‘political crises’, which we call as the Black Wednesday (Sept 1992).

No rumor had caught fire this quick in history, and as the bank’s, dealers and brokers sold the pound, the speculators like Soro’s joined the league, when the ERM deal seemed to be falling off the edge.  He sold 10 billion worth pounds when the sterling was still high hoping to buy back cheaply when it devalued making a fortune. Ironically, the bank of England working against the odds had to spend billions of pounds in the defense of the pounds. And this proved to Soro’s that he was at the ‘end game’, an invitation to double-up and tread towards his victory, making 1 billion in profit.