Read Online The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It by Scott Patterson - Free Book Online
Authors: Scott Patterson
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known as statistical arbitrage, or stat arb—one of the most powerful trading strategies ever devised, a nearly flawless moneymaking system that could post profits no matter what direction the market was moving.
It was right up Thorp’s alley.
Gerry Bamberger discovered stat arb almost by accident. A tall, quick-witted Orthodox Jew from Long Island, he’d joined Morgan Stanley in 1980 after earning a degree in computer science at Columbia University. At Morgan, he was part of a group that provided analytical and technical support for the bank’s stock trading operations.
In this capacity, Bamberger wrote software for Morgan’s block trading desk, which shuffled blocks of ten thousand or more shares at a time for institutional clients such as mutual funds. The block traders also used a “pairs strategy” to minimize losses. If the desk held a block of General Motors stock, it would sell short a chunk of Ford that would pay off if the GM stock took a hit. Bamberger’s software provided traders up-to-date information on the relative positions of the pairs.
Bamberger noticed that large block trades would often cause the price of the stock to move significantly. The price of the other stock in the pair, meanwhile, barely moved. This pushed the typical gap between the two stock prices, the “spread,” temporarily out of whack.
Suppose GM typically traded for $10 and Ford for $5. A large buy order for GM could cause the price to rise temporarily to $10.50. Ford, meanwhile, would stay at $5. The “spread” between the two stocks had widened.
By tracking the historical patterns and moving with cheetah-quick speed, Bamberger realized he could take advantage of these temporary blips. He could short a stock that had moved upward in relation to its pair, profiting when the stocks returned to their original spread. He could also take a long (or short) position in the stock that hadn’t moved, which would protect him in case the other stock failed to shift back to its original price—if the historical spread remained, the long position would eventually rise.
Much like Thorp’s delta hedging strategy, it was the old game of buy low, sell high, with a quant twist.
After describing his ideas to his superiors, Bamberger was set up on Morgan’s equity desk in early 1983 with $500,000 and a small group of traders. He started making buckets of cash right out of the gate. By September, his group had $4 million worth of long and short positions. In early 1984, it had $10 million. The stake rose to $15 million in October. By 1985, the group was running a $30 million book.
But almost as fast as Bamberger scaled the heights, he came crashing down. Morgan’s higher-ups, reluctant to leave such a money machine in the hands of a programmer, turned it over to a hired gun named Nunzio Tartaglia. Bamberger, outraged, quit the firm.
The Brooklyn-born Tartaglia was a mass of contradictions. He’d earned a master’s degree in physics from Yale University in the early 1960s, then promptly joined the Jesuits. After five years, he left the seminary to earn a Ph.D. in astrophysics from the University of Pittsburgh. By the early 1970s, Tartaglia found himself working on Wall Street as a retail broker at Merrill Lynch. After Merrill, the peripatetic Tartaglia went to five other firms before landing at Morgan in 1984.
He renamed the group he’d taken over Automated Proprietary Trading, or APT, and moved it to a single forty-foot-long room on the nineteenth floor in Morgan’s Exxon Building headquarters in mid-town Manhattan. Tartaglia added more automation to the system, linking the desk to the New York Stock Exchange’s Super DesignatedOrder Turnaround System, or SuperDOT, which facilitated computerized trades. APT was soon trading so much that at times it accounted for 5 percent of the daily trading volume on the NYSE. The stat arb strategy earned $6 million in the first year Tartaglia ran the group. In 1986, it pulled in an
It was right up Thorp’s alley.
Gerry Bamberger discovered stat arb almost by accident. A tall, quick-witted Orthodox Jew from Long Island, he’d joined Morgan Stanley in 1980 after earning a degree in computer science at Columbia University. At Morgan, he was part of a group that provided analytical and technical support for the bank’s stock trading operations.
In this capacity, Bamberger wrote software for Morgan’s block trading desk, which shuffled blocks of ten thousand or more shares at a time for institutional clients such as mutual funds. The block traders also used a “pairs strategy” to minimize losses. If the desk held a block of General Motors stock, it would sell short a chunk of Ford that would pay off if the GM stock took a hit. Bamberger’s software provided traders up-to-date information on the relative positions of the pairs.
Bamberger noticed that large block trades would often cause the price of the stock to move significantly. The price of the other stock in the pair, meanwhile, barely moved. This pushed the typical gap between the two stock prices, the “spread,” temporarily out of whack.
Suppose GM typically traded for $10 and Ford for $5. A large buy order for GM could cause the price to rise temporarily to $10.50. Ford, meanwhile, would stay at $5. The “spread” between the two stocks had widened.
By tracking the historical patterns and moving with cheetah-quick speed, Bamberger realized he could take advantage of these temporary blips. He could short a stock that had moved upward in relation to its pair, profiting when the stocks returned to their original spread. He could also take a long (or short) position in the stock that hadn’t moved, which would protect him in case the other stock failed to shift back to its original price—if the historical spread remained, the long position would eventually rise.
Much like Thorp’s delta hedging strategy, it was the old game of buy low, sell high, with a quant twist.
After describing his ideas to his superiors, Bamberger was set up on Morgan’s equity desk in early 1983 with $500,000 and a small group of traders. He started making buckets of cash right out of the gate. By September, his group had $4 million worth of long and short positions. In early 1984, it had $10 million. The stake rose to $15 million in October. By 1985, the group was running a $30 million book.
But almost as fast as Bamberger scaled the heights, he came crashing down. Morgan’s higher-ups, reluctant to leave such a money machine in the hands of a programmer, turned it over to a hired gun named Nunzio Tartaglia. Bamberger, outraged, quit the firm.
The Brooklyn-born Tartaglia was a mass of contradictions. He’d earned a master’s degree in physics from Yale University in the early 1960s, then promptly joined the Jesuits. After five years, he left the seminary to earn a Ph.D. in astrophysics from the University of Pittsburgh. By the early 1970s, Tartaglia found himself working on Wall Street as a retail broker at Merrill Lynch. After Merrill, the peripatetic Tartaglia went to five other firms before landing at Morgan in 1984.
He renamed the group he’d taken over Automated Proprietary Trading, or APT, and moved it to a single forty-foot-long room on the nineteenth floor in Morgan’s Exxon Building headquarters in mid-town Manhattan. Tartaglia added more automation to the system, linking the desk to the New York Stock Exchange’s Super DesignatedOrder Turnaround System, or SuperDOT, which facilitated computerized trades. APT was soon trading so much that at times it accounted for 5 percent of the daily trading volume on the NYSE. The stat arb strategy earned $6 million in the first year Tartaglia ran the group. In 1986, it pulled in an
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